Where you hold your investments matters. Mutual funds or ETFs? Why life insurance still plays an important estate planning role

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1 spring 2016 Where you hold your investments matters Mutual funds or ETFs? Why life insurance still plays an important estate planning role Should you undo a Roth IRA conversion?

2 Taxable vs. tax-advantaged accounts Where you hold your investments matters When investing for retirement or other long-term goals, people usually prefer tax-advantaged accounts, such as IRAs, 401(k)s or 403(b)s. Certain assets are well suited to these accounts, but other investments make far more sense for traditional taxable accounts. Knowing the difference can help bring you closer to your financial goals. Understand how they re taxed Where you own assets matters because of how they re taxed. Some investments, such as fastgrowing stocks, can generate substantial capital gains, which occurs whenever you sell a security for more than you paid for it. When you ve owned that position for over a year, you face longterm gains, taxed at a maximum rate of 20%. In contrast, short-term gains, assessed on holding periods of a year or less, are taxed at your ordinary-income tax rate maxing out at 39.6%. Meanwhile, if you own a lot of income-generating investments, you ll need to pay attention to the tax rules for dividends, which belong to one of two categories: Qualified. These dividends are paid by U.S. corporations or qualified foreign corporations. Assuming you ve met the applicable holding period requirements, qualified dividends are, like long-term gains, subject to a maximum tax rate of 20%. Nonqualified. These dividends which include most distributions from real estate investment trusts (REITs) and master limited partnerships (MLPs) receive a less favorable tax treatment. Like short-term gains, nonqualified dividends are taxed at your ordinary-income tax rate. Choose tax-efficient options Generally, the more tax efficient an investment, the more benefit you ll get from owning it in a taxable account. Conversely, investments that lack tax efficiency normally are best suited to tax-advantaged vehicles. Consider municipal bonds ( munis ), either held individually or through mutual funds. Munis are particularly attractive to tax-sensitive investors because their income is exempt from federal income taxes and sometimes state and local income taxes as well. Because you don t get a double benefit when you own an already tax-advantaged security in a taxadvantaged account, holding munis 2 Wealth Management Advisor

3 in your 401(k) or IRA would result in a lost opportunity. Similarly, tax-efficient investments such as passively managed index mutual funds or exchange-traded funds, or long-term stock holdings, are generally appropriate for taxable accounts. Over time, these securities are more likely to generate long-term capital gains, whose tax treatment is relatively favorable. Securities that generate more of their total return via capital appreciation or that pay qualified dividends are also better taxable account options. Take advantage of income What investments work best for tax-advantaged accounts? Taxable investments that tend to produce much of their return in income, for one. This category includes corporate bonds, especially high-yield bonds, as well as REITs, which are required to pass through most of their earnings as shareholder income. Most REIT dividends are nonqualified and therefore taxed at your ordinaryincome rate. Another tax-advantaged-appropriate investment may be an actively managed mutual fund. Funds with significant turnover meaning their portfolio managers are actively buying and selling securities have increased potential to generate short-term gains that ultimately get passed through to you. Because short-term gains are taxed at a higher rate than long-term gains, these funds would be less desirable in a taxable account. Think beyond taxes The above concepts are only general suggestions for taxable and taxadvantaged accounts. You may, for example, need more liquidity in your taxable account than you do in your IRA account. In this case, you might decide to hold a high-turnover equity fund or high-yield bond investments in the taxable account because you value flexibility more than favorable tax treatment. Just keep in mind the benefits and risks including the risk that your investments will lose value associated with any investment decision, and know that tax issues can be complex. Ask your Lenox Advisor to help you make the best choices for your situation. Wealth Management Advisor 3

4 Mutual funds or ETFs? Understand the differences before you choose Mutual funds* have been around for nearly a century. Exchange-traded funds, or ETFs, are the newer kid on the block. The two investment types have much in common, but also important differences that make each more appropriate for some situations than others. Passive or active ETFs have quickly assumed a prominent place on the U.S. investment landscape. In late 2014, more than $2 trillion in net assets were held in 1,400 ETFs up from a single offering in 1993 and fewer than 100 in Despite this growth, mutual funds remain dominant. According to the Investment Company Institute, there are nearly $16 trillion of assets owned across close to 8,000 mutual funds. There are two basic types of mutual funds: actively managed and indexbased. With actively managed funds, a portfolio manager decides which securities to buy and sell to give the fund the best opportunity to outperform a benchmark index. Index funds, however, are passively managed, meaning they re designed to replicate a benchmark s characteristics and match its performance. Despite a small number of actively managed ETFs, the vast majority are passive investments. They re designed to track a particular benchmark, making them most similar to index mutual funds. Differences in pricing Even though index funds and ETFs share many characteristics, they also have significant differences. For starters, investors in mutual funds generally buy and sell shares directly from a fund company. The shares are priced once per trading day after the close of trading, and investors must buy before then to receive that day s price. ETF shares, in contrast, are transacted on stock exchanges via a brokerage account. Their prices fluctuate throughout the day based on supply and demand. This means that shares sometimes temporarily trade at a premium or discount to their underlying investment s net asset value (NAV). If the gap between share price and NAV gets too wide, buyers or sellers theoretically emerge to bring the prices back in line. However, in practice, the price discrepancy can persist for days or even longer. Another key difference is that, just as with stock trades, investors incur *Consider the investment objectives, risks, charges and expenses of mutual funds carefully before investing. For this and other information about the mutual funds you re considering, please read the prospectus carefully before investing. Mutual fund investment values will fluctuate, and shares, when redeemed, may be worth more or less than original cost. 4 Wealth Management Advisor

5 But it s important to note that, if you own mutual funds in a taxadvantaged retirement account, such as an IRA, your purchases and sales do not involve capital gains. What s more, fund distributions don t result in tax. brokerage commissions each time they buy and sell ETFs. Thus, the more frequently you transact, the higher your cost of ownership. Buying mutual fund shares directly from a fund company is usually commission-free (although some funds do have sales charges, or loads ). gains that are passed through to individual shareholders, even those who never sell their own fund holdings. Because ETFs are transacted privately between buyers and sellers, investors have significantly more control over their taxes. Consider your goals Both mutual funds and ETFs can help you achieve your investment objectives. But both also carry risks including the risk that they ll decline in value and you ll lose money you ve invested in them. Discuss your goals and risk tolerance with your financial advisor and he or she can help guide you to the most appropriate investment. Because most ETFs are passively managed, they tend to have low expenses, especially compared with actively managed mutual funds. Index mutual funds also generally have low expenses. Tax treatment varies Most ETFs are tax efficient, especially compared to actively managed mutual funds, because they aren t required to make distributions. ETFs are also typically more tax efficient than index mutual funds. When index funds need to redeem shares, portfolio managers may have to sell stock to generate cash. This can create capital Consider your objectives Your individual situation will determine whether you re best suited to an exchange-traded fund (ETF) or a traditional mutual fund. If you want a chance to beat the market (by, for example, outperforming the S&P 500 index), you ll probably want to consider an actively managed mutual fund. Of course, despite their best intentions, many active managers wind up trailing their benchmark because of higher expenses and other factors. It s important to think about your investment goals and timing. If you plan to make small, regular investments for a longterm objective, you might be better off setting up an automatic investment plan with a mutual fund company. That way, your frequent purchases will be free of transaction costs. ETFs, meanwhile, may be more cost effective if you re making a larger, one-time investment. Exchange-traded funds (ETFs) don t sell individual shares directly to investors and only issue their shares in large blocks. ETFs are subject to risks similar to those of stocks. Consider the investment objectives, risks, and charges and expenses of ETFs carefully before investing. Investment returns will fluctuate and are subject to market volatility, so that an investor s shares, when redeemed or sold, may be worth more or less than their original cost. Wealth Management Advisor 5

6 Why life insurance still plays an important estate planning role Because the estate tax exemption currently tops $5 million, fewer people need life insurance to provide their families with the liquidity to pay estate taxes. But life insurance can still play an important part in your estate plan, particularly in conjunction with charitable remainder trusts (CRTs) and other charitable giving strategies. Home for highly appreciated assets CRTs are irrevocable trusts that work like this: You contribute property to a CRT during your life or upon your death and the trust makes annual distributions to you or your beneficiary (typically, your spouse) for a specified period of time. When that period ends, the remainder goes to a charity of your choice. These instruments are particularly useful when you contribute highly appreciated assets, such as stock or real estate, and want to reduce capital gains tax exposure. Because the CRT is tax-exempt, it can sell the assets and reinvest the proceeds without currently triggering the entire capital gain. Another benefit is that, if you opt to receive annual distributions from your trust, that income stream generally will be taxed at a lower rate than other income using a formula that combines ordinary taxable income, tax-exempt income, capital gains and other rates. Here s where life insurance comes in. Because CRT assets eventually go to charity usually after both you and your spouse have died you won t have as much to leave to your children or other heirs. A life insurance policy can replace that lost wealth in a tax advantaged way. Charities as beneficiaries CRTs are ideal for philanthropically minded individuals. But there are other ways to use life insurance to fund charitable gifts and enjoy tax benefits. You might, for example, transfer your policy to a nonprofit organization and take a charitable income tax deduction (subject to certain limitations) for it. If you continue to pay premiums on the policy after the charity becomes its owner and beneficiary, you can take additional charitable deductions. Another scenario is to just name a charity as your policy s beneficiary. Because you retain ownership, you can t take charitable income tax deductions during your life. But when you die, your estate will be entitled to an estate tax charitable deduction. Here s a third idea. Instead of leaving your IRA or other retirement accounts to your heirs, thus forcing them to pay income tax on any distributions, designate these investment accounts for charity. Then buy a life insurance policy equal to the value of the donated assets to leave to your family. You might even want to pay the policy s premiums with after-tax funds from a retirement account. Wealth replacement tool Life insurance can be used to replace wealth in many circumstances not only when you re donating to charity. For instance, if you ve decided to forgo long term care (LTC) insurance and pay any LTC-related expenses (such as home nursing services or care in a nursing facility) out of pocket, you may not have as much to leave your heirs. Life insurance can help ensure that you provide your family with an inheritance. Or, say you re a business owner who intends to leave the company to one of your children who you believe can run it successfully. That may leave other children who won t inherit the business. If you don t have adequate assets outside your company to equalize your children s shares, life insurance proceeds can help bridge that gap. Multiple benefits Estate taxes may no longer be a concern if your estate is valued at less than $5.45 million. But, depending on your goals, life insurance can help you make charitable gifts, leave money to your heirs and realize tax advantages. Talk to your Lenox Advisor about the types of policies that might be appropriate for estate planning purposes. 6 Wealth Management Advisor

7 Should you undo a Roth IRA conversion? Converting a traditional IRA to a Roth IRA can provide tax-free growth and the ability to withdraw funds tax-free in retirement. But what if you convert a traditional IRA subject to income taxes on all earnings and deductible contributions and then discover that you would have been better off if you hadn t converted it? Fortunately, it s possible to undo a Roth IRA conversion, using a recharacterization. Reasons to recharacterize There are several possible reasons to undo a Roth IRA conversion. For example: You lack sufficient liquid funds to pay the tax liability. The conversion combined with your other income has pushed you into a higher tax bracket. Your income is likely to drop in retirement, reducing or eliminating the benefits of a Roth IRA. The value of your account has declined since the conversion, which means you would owe taxes partially on money you no longer have. Generally, when you convert to a Roth IRA, you have until October 15th of the following year (if you extend your tax return) to undo it. Then, you must wait to once again convert to a Roth IRA until the later of 1) the first day of the year following the year of the original conversion, or 2) the 31st day after the recharacterization. Keep in mind that, if you reversed a conversion because your IRA s value declined, there s a risk that your investments will bounce back during the waiting period. This could cause you to reconvert at a higher tax cost. Recharacterization in action The following example illustrates the process. Nick has a traditional IRA with a balance of $100,000. In December 2016, he converts it to a Roth IRA and normally would owe $33,000 in federal income taxes in April However, Nick extends his return and, by September 2017, the value of his account has dropped to $80,000. On October 1, Nick recharacterizes the account as a traditional IRA and files his return to exclude the $100,000 in income. On November 1, he reconverts the traditional IRA, whose value remains at $80,000, to a Roth IRA, and reports that amount on his 2017 tax return. This time, he owes $26,400 deferred for a year and resulting in a tax savings of $6,600. Keep your options open If you convert a traditional IRA to a Roth IRA, monitor your financial situation. If the advantages of a Roth IRA diminish, talk to your Lenox Advisor about your options. Wealth Management Advisor 7

8 Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC, 530 Fifth Avenue, 14th Floor, New York, NY 10036, Fee based financial planning services are offered through Lenox Advisors, Inc., a registered Investment Advisory Firm, and are not offered or sponsored by MML Investors Services, LLC. Lenox Advisors, Inc. is not a subsidiary of or affiliated with MML Investors Services, LLC. Lenox Advisors, Inc. is a wholly owned subsidiary of NFP. NFP is not an affiliate of subsidiary of MML Investors Services, LLC. CRN

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