Haft of It

THE HAFT
OF IT
A collection of the most popular
financial planning newspaper
columns by

ALAN HAFT
© 2007 by TriMark Press, Inc.
This book is intended for general information purposes only. While the
publisher and author have utilized their best efforts in preparing this book, they
make no claims or warranties with respect to the accuracy or completeness of
the contents. The information may not be applicable to you and is intended
for general demonstration purposes only. There are many exceptions to the
general principles stated herein. Before you apply or act on this or any other
legal, investment, funding, tax, insurance or other financial information, you
should consult with a financial planner who can evaluate the facts of your
specific situation and advise you on the proper course of action based on that
evaluation.
All rights reserved. No portion of this publication may be reproduced or

transmitted in any form or by any means, electronic, mechanical or otherwise,
including photocopy, recording, or any information storage or retrieval system
now known or to be invented without permission in writing from the author,
except by a reviewer who wishes to quote brief passages in connection with
a review. Requests for permission should be addressed in writing to the
author.
ISBN: 978-0-9767528-7-5
Published in Boca Raton, Florida, by TriMark Press, Inc.

800.889.0693
Printed and bound in the United States of America.
Alan Haft
alanhaft.com
800-809-4699
DISCLAIMER
Everyone’s personal situation is uniquely different. Investments, taxes
and estate planning concepts addressed during the course of the book
are complex subjects. With this in mind, please be sure to consult with
a qualified tax, estate and/or investment advisor(s) before any action is
taken. Furthermore, because articles in this book are reprints from
various newspaper columns, some of the information might be outdated.

CONTENTS
About the Author
Introduction
Chapter 1: Retirement Planning

Five Common Investment Mistakes............................................................... 15
Considering a Financial Advisor?.................................................................. 19
Interviewing Your Next Financial Planner...................................................... 25
Custodial Accounts and Trusts....................................................................... 28
Employer-Sponsored Retirement Plans........................................................... 31
Year-End Checklist......................................................................................... 34
Will Your Well Run Dry?................................................................................ 38
Chapter 2: Investing
The Benefits of Diversification........................................................................ 41
The Index Advantage and Exchange-Traded Funds........................................ 46
Small Company Stocks................................................................................... 49
Real Estate Investment Trusts......................................................................... 52

Chapter 2: Investing (continued)

Evaluating Performance................................................................................. 55
Portfolio Rebalancing..................................................................................... 58
6 Things Dating Teaches Us About Money..................................................... 61
7 Ways to Save $100 per Month.................................................................... 66
Chapter 3: Income
More Income, Less Risk ................................................................................. 71
Build a Bond Ladder...................................................................................... 75
The Power of Dividends ................................................................................ 85
Preferred Stocks . ........................................................................................... 88
Real Estate Without the Headache ................................................................ 91
Government-Backed Mortgage Securities . .................................................... 94
Chapter 4: Bonds
Understanding the Effect of Interest Rates...................................................... 97
The Attraction of Bond Funds...................................................................... 101
Chapter 5: Annuities
Index Annuities ........................................................................................... 105
Variable Annuities ...................................................................................... 110
When You Need the Cash Now ................................................................... 113

Chapter 6: IRAs
Frequently Asked Questions ........................................................................ 117
Converting to a Roth IRA............................................................................. 120
Liquidate Your IRAs? . ................................................................................. 123
Beneficiaries and Required Distributions..................................................... 127
Extending the Life of Your IRA .................................................................... 130
Create Your Own Private Pension Plan........................................................ 132
Self-Directed IRAs ...................................................................................... 137
Chapter 7: Taxes
Understanding Tax Efficiency ...................................................................... 141
Taking Advantage of the 2003 Tax Act ........................................................ 144
The New Tax Law ........................................................................................ 147
Reducing Capital Gains and Estate Taxes ................................................... 150
How Will You Spend Your Tax Refund? . ...................................................... 153
Chapter 8: Economy
Not Concerned about the Federal Budget? .................................................... 157
Currency Values........................................................................................... 160
The Price of Crude ...................................................................................... 163
The Threat of Inflation ................................................................................ 166
Chapter 9: Estate Planning

Isn’t a Will Enough? . .................................................................................. 169

Chapter 10: Long-Term Care

Long-Term Care Insurance . ........................................................................ 173
Medicaid Eligibility .................................................................................... 176
Medicare Prescription Drug Plans .............................................................. 179
Chapter 11: Gifting

The Gift of a Lifetime .................................................................................. 181
Chapter 12: Education

Not for School Only .................................................................................... 185
Chapter 13: The 10 Commandments of Investing

..................................................................................................................... 189
Conclusion
..................................................................................................................... 193

ABOUT THE AUTHOR
Alan Haft is a nationally recognized investment advisor who has been

featured in a variety of media outlets including Money Magazine,
Forbes, Morningstar, BusinessWeek, The Los Angeles Times, The
Chicago Tribune and many others.
His financial column“The Haft of It”appears in a variety of newspapers

around the country and he has two books soon to be published
including “The 10 Most Common Mistakes People Make With Their
Money… and how to avoid them” and “You Can Never Be Too Rich…
simple and essential investment advice you cannot afford to overlook”(John
Wiley & Sons, November 2007).
With his partners, he has conducted hundreds of financial planning

seminars and workshops. The firm currently services retirees and pre-
retirees in southeast Florida, southern California, the New York Tri-
State area and many other areas around the country.
For more information, please visit www.alanhaft.com

PREFACE
As a financial advisor, I find many of the questions investors ask

generally fall into four main areas:
• How do I keep my money safe?
• How do I keep my money growing ahead of inflation?
• How do I minimize taxes for myself and for heirs?
• How do I make sure I do not outlive my money?
These concerns kept arising during many conversations with clients

and over the years, I felt I should create some type of written material
to answer them. I felt if I could just address the most frequent concerns
and misconceptions about various financial topics, I believed a lot of
people could benefit from some informal handouts.
So that’s what I did. I wrote a few answers to the “frequently asked

questions” and put together some handouts for people coming into
our office. One of the individuals who came in to meet with me had
a contact with a local newspaper and as a result, he asked if I’d be
interested in providing information in the form of a column. That’s
when my financial column – “The Haft of It” – was born. A positive
response from readers led the newspaper to ask for more content and
pretty soon, other papers were carrying the columns as well. Using
the feedback I received after the publication of my first few columns,
I wrote the next set. Whether readers wanted to know how dividend-
paying stocks worked or where they could get a better return on
their CDs, I answered their questions with more and more columns.
Eventually, the columns were distributed in papers and various media
outlets across the country.
10
This book is a collection of columns I wrote. Out of all the columns I’ve
written, those found in this book are the ones that generated significant
feedback, questions, and, quite frankly, the most “thanks for writing
that” comments. Some issues are timeless, while others will one day
become outdated. Regardless, for now and the foreseeable future, these
issues underscore the importance of understanding what’s happening
with your money even if you’re looking to others for advice.
*Note to readers: Everyone’s personal situation is uniquely different. Investments,

taxes and estate planning concepts addressed during the course of the book are
complex subjects. With this in mind, please be sure to consult with a qualified tax,
estate and/or investment advisor(s) before any action is taken. Furthermore, because
articles in this book are reprints from various newspaper columns, some of the
information might be outdated.
11
INTRODUCTION
Most of us have been on a road trip at some point in our lives. The
trip may have focused on business, or it may have been for pleasure.
In either case it required preparation and much of that preparation
is similar, regardless of the trip’s purpose. If you want your trip to be
successful and uneventful, there are always a few necessary steps to
take before you hit the road.

Of course, the first step you must take before setting out on your
journey is to first determine your intended destination. It may be
across the border into another country, into another state or down the
block. But even if it’s local, you still need to plan your route. Whenever
you’re headed into an area that you’re unfamiliar with, you will likely
need some sort of road map. Longer journeys will require plotting out
highways and other major thoroughfares. Then, once you get into an
unknown city or town, you will most certainly need a more detailed
street map to get you to your destination.
Now, what about your vehicle or how you’ll actually get to your
destination? The make and model doesn’t matter so much as does its
condition. Is it in good shape? Are all of its systems operating correctly?
Do you have a full tank of gas? Have you checked the oil and tire
pressure? You need to make sure all of the parts of your vehicle are
operating before you head out on your trip. You certainly don’t want to
break down somewhere along the road.
Your financial future is really no different. Your first step is to at least

have some idea of where you’re going or, better stated – your financial
12
goals. While you may likely have a long-term goal in mind (such as
retirement), you may also have several short-term, intermediate goals.
You may wish to purchase a second home, help your children with
various expenses or make donations to charities. With proper foresight,
you can arrange to arrive safely at both your long-term and short-term
destinations. Yet besides knowing your destination, or goal, you’ll also
need a good road map and a sound vehicle.
Many of my clients are retirees or they’re near retirement. When they’ve

arrived at their destination – in this case, retirement – their lifestyle
changes and so must their route, or their investment strategy. They’ve
been accustomed to investing for growth and wealth accumulation,
making as much money as possible so they could live off their portfolio
in retirement. But many times, once they retire, they often forget that
their destination has changed – they’ve already reached retirement.
Now that they’re in their retirement years, their plans for getting to
their destination and the investing habits and strategies they’ve been
using need to change as well. The bumpy dirt roads they’ve traveled
in the past should be replaced with paved freeways. They must make
the transition from wealth accumulation to wealth preservation and in
later years, the focus should be on wealth transfer.
Most importantly, your vehicle must be prepared for retirement, since

once you arrive at retirement years, you’ll be driving this same vehicle
presumably for the rest of your life. Most of us won’t have much of an
opportunity to build additional wealth, and that’s not what retirement
is about anyway. If you’re like most people, you’ll want to be able to
enjoy your post-work life as much as you can and make certain you can
afford ongoing living expenses as well as have money for the things
you’d like to do and were probably looking forward to for all those
working years. What good is it to have a retirement vehicle if you can’t
play a round of golf every once in a while or go off on some of those
adventures you’ve been thinking about? That can only happen if you
have at least a basic understanding of how your vehicle operates.
Wouldn’t it be helpful if you had a manual of some kind so you could

at least become familiar with your retirement vehicle? Consider the
columns that follow – and this book – as a helpful manual for your
13
retirement vehicle or at least information covering some of its “basic”

parts. This “how-to” troubleshooting guide will assist you in steering
through the years up to retirement and making sure your retirement
vehicle itself is kept in good working order. While this book is not
meant to be an encyclopedia of retirement that covers all issues, The
Haft of It columns were created to help clients understand some of the
basics of what drives an investment vehicle. These are the areas I’ve
received many questions about and the columns that resulted in the
greatest amount of feedback. They will help you learn how to monitor
the gauges and what to look for while you’re on the road, to make sure
your engine isn’t low on oil or you don’t run out of gas.

The following chapters cover a variety of subjects. After all, to build a
well-performing vehicle, you cannot only focus on the fuel. You need
to consider the oil, transmission, steering system, air filter, spark plugs,
belts, tires, radiator, etc. Ignore one thing and the entire vehicle could
easily break down. These components together drive your retirement
vehicle. Although all of the parts are important, the columns are
grouped by subject matter and are not necessarily in any order of
priority.
Not only are investments covered in this book, but other areas of
financial planning as well. If properly monitored and adjusted, they
will also help you get to where you want to go. Parts of your retirement
vehicle include money, taxes, fees, estate planning, medical planning
and a long list of other things.You don’t need to know who makes your
radiator coolant, however, you do need to know when you’re having
a problem that involves your radiator. That means monitoring your
dashboard gauges to make sure your vehicle isn’t overheating. And
if something does break down, you need to be able to pull out the
manual from the glove compartment to get a better idea of what’s
going on.
When a prospective client asks “What can you do for me?” I answer
that I can help them very clearly define their financial goal, or
destination, and then help them match that goal as precisely as
possible with whatever products, or components, will best get them
there. One particular vehicle, or combination of components, doesn’t
14
necessarily fit everyone, even though they may be retired. Just because
you’re at the same point in your life – when you should be protecting
the wealth you’ve accumulated – does not mean you should have the
same investments, insurance, etc., as everyone else. You may need a
Mercedes, while a Cadillac or Lincoln is more appropriate for someone
else. One is not necessarily better than the others. All three vehicles
will carry you through retirement but in a slightly different way. While
there are many good “components” on the market that will help drive
your vehicle, everyone’s needs are different and these parts must be
considered on an individual basis.
One thing in planning for retirement does not change: You’ll still need
to review your map, or your investment plans, regularly to make sure
you’re on course. Comparing your actual performance to what you
had planned is the only way you will know whether you’re on track.
Construction zones, detours, and accidents may occur over time and
can delay your progress if you’re not alert. These unexpected incidents
may require you to change your route, or the roads you are using to
get you through retirement. Routine vehicle maintenance will also be
required from time to time. But if you keep an eye on your destination,
your map, and your vehicle by monitoring its gauges, you’ll be able
to alter your route slightly, replace a couple of components now and
then, and stay on the road. It’s only through your understanding of
what’s needed and your regular involvement that you will be able to
ride through your retirement years safely and comfortably.
So from me to you, here’s hoping that your retirement vehicle will be

able to take you on the wonderful trip you envisioned – with beautiful
scenery, interesting places, and memorable people. May the operating
manual provided here help ensure that you’re well-prepared for
whatever you encounter. And when it’s time to hand your keys over to
the next generation, may they inherit a vehicle that’s not only served
you well, but one that will provide a nice ride for many more miles to
come.
Happy driving…

ONE
RETIREMENT PLANNING CHAPTER 15
Five Common Investment Mistakes

How many are you making?
So you think you’re ready for retirement? Don’t be so sure. With people
today living longer and leading more active retirement lifestyles than in
the past, you may need to set aside more money and invest differently
than you had planned.
You’ve probably heard the saying “people who fail to plan, plan to
fail”.That certainly holds true when it comes to your retirement. To
have the best chance of living in the style you’ve become accustomed
to during your earning years, it’s essential that you make time as soon
as you can to properly plan for the years when you won’t be actively
employed. Coming up short could be a rude awakening when you’ve
already decided to stop working at a certain age.
Starting sooner is always better. It requires you to set aside fewer

dollars at a time, gives your money a longer period in which to grow,
and makes it easier for your investments to weather the ups and downs
16 RETIREMENT PLANNING
of the markets. But you probably know all that, even if you’ve put off
planning.
What you may not know is that there are strategies than can help you
maximize your investment dollars, which aren’t always so obvious.
There’s also much more to retirement planning than just saving and
investing. There are tax issues, estate planning, and the list goes on.
Of course you can always seek the advice of a qualified financial
advisor if you need assistance, yet finding the right financial advisor
takes some planning too.
In this chapter, we’ll cover some retirement planning points you need
to know about so you can make sure that you have the retirement you
deserve. We’ll start with a list of five common mistakes that people
make when planning for retirement.
1. Thinking it’s too late to start planning.

Once you reach your 50’s or 60’s, it may seem too late to start
investing. After all, how can you possibly accumulate enough
money to make a difference when you retire? Fortunately for you,
thanks to the power of compounding, boosted by the tax-deferred
growth offered by individual retirement accounts (IRAs), 401(k)
plans, and annuities, it may not take as much as you think to build
up a sizeable nest egg.
2. Underestimating your life expectancy.

Although you may think you have an idea as to how long you’ll live
in retirement, life expectancies are increasing and you may need to
plan for a much longer retirement than you initially anticipated.
Almost 20% of workers expect their retirement to last 10 years
or less, while an additional 15% expect their retirement to last
11 to 19 years. But according to the 2000 Retirement Confidence
Survey by the Employee Benefit Research Institute (EBRI), half of
the men who reach age 65 have an additional life expectancy of
approximately 17 years, while half of the women reaching age 65
can expect to live for about another 21 years.
RETIREMENT PLANNING 17
3. Not calculating your savings needs.

Most financial planners will tell you to plan on needing 60% to 85%
of your pre-retirement income to maintain your standard of living
in your retirement years. I’ve heard another “simple” formula that
merely says you should multiply your annual income requirement
times 25. Yet can you really predict how much you’ll need based
on general percentages or formulas? According to the EBRI survey,
only 53% of those currently employed have tried to determine how
much money they’ll need to save by the time they retire. And half
of the workers who did try to estimate their financial requirements
in retirement increased their investments or changed their asset
allocation as a result of their calculations. This suggests that many
people may not be correctly estimating the amount of money they’ll
need when they retire. But with software and online calculators,
it’s easy to work through that equation properly. Quicken offers a
calculator, as do many mutual fund companies. One fund company
in particular – T. Rowe Price www.troweprice.com – has some of the
best tools available, such as my personal favorite, their Retirement
Income Calculator.
4. Not taking inflation into account.

Many investors, particularly those who are older, are uncomfortable
with market volatility. As a result, they invest solely in Treasury bills,
fixed-rate CDs, and savings accounts. What they may not realize
is that doing so will likely eat away at most of their investment
return because these vehicles tend to provide rates close to or less
than inflation. As you approach retirement – and even after you’ve
retired – it’s important to consider keeping some of your money
in growth investments, such as stocks and low-cost stock mutual
funds.You need a higher rate of return so your money will continue
to grow and you can stay ahead in the investing game. Needless
to say, if you are at a much later stage of retirement, vehicles such
as CDs and other safe instruments are completely acceptable,
especially if they are generating the income one requires.
5. Putting other financial goals first.

Saving for retirement probably isn’t your only financial goal. You
may also be saving for your children’s or grandchildren’s college
education, or for the down payment on a second home. While
these other goals are certainly important, it’s not a good idea to
place them ahead of a financially secure retirement. It’s easier to
fund your retirement account with smaller amounts of money now
than try to catch up later. You’ll also lose the advantage that comes
from years of compounding and tax deferral if you wait until you’ve
funded your short-term goals first.
Considering a Financial Advisor?

Key questions to ask.
According to some estimates, half a million people in the United States
call themselves financial advisors. But not all are. By legal definition,
a “stockbroker” is not a “financial advisor”. At the time of this writing,
the definition of a “financial advisor” is very murky, and there are a
lot of debates going on as to whether or not someone can use this
title with only a “stockbroker’s” license. Personally, although the ability
to “pick” investments does require talent, I firmly believe entrusting
your retirement to a person who only has a stockbroker’s license is a
dangerous proposition given, that there are so many other important
parts to one’s overall retirement vehicle.
So how do you know if the person you’re considering is really qualified?

That’s pretty tricky. Needless to say, a great recommendation is always
helpful, but from the feedback I’ve gotten across the country a “great
recommendation” is often tough to find.
Here are some key points to keep in mind when making your
decision:
1. What do the acronyms following the advisor’s name (if any) really
mean?
It’s important that you understand the alphabet soup. The letters
following a financial advisor’s name can stand for education,
experience, or registration with a trade association. (See the
accompanying list on page 23 for a guide to the definitions of some
of the more common financial designations.)
2. Is this person really a financial advisor?

Know what’s behind the “financial advisor” title. As I mentioned
above, many stockbrokers call themselves financial advisors
when, in fact, they are not. Generally, a Certified Financial
Planner and a Registered Investment Advisor (RIA) is
truly a financial advisor due to licensing and educational
requirements. Personally, I would not consider anyone to watch
over my investments unless they had this license or were a
Certified Financial Planner (CFP).
3. What licenses does the financial advisor hold?

The National Association of Securities Dealers (NASD) works to
protect the public by requiring individuals to pass a Registered
Representative (RR) exam before they can sell a product. The two
major exams and related licenses are the Series 6 and Series 7. A
financial advisor who holds a Series 6 license can sell only mutual
funds and variable annuities, which is fine if that’s all you want
to buy. But a financial advisor who holds a Series 7 license can
sell you many types of securities – except commodities and futures
– which gives you more investment options.
Given someone with a Series 6 license can only sell you mutual
funds or variable annuities, I would recommend considering
someone with a Series 7 license to compare plans. At the far end
of the extreme are individuals promoting only insurance products
such as fixed annuities and/or life insurance. These people can’t
recommend any securities products, such as bonds, which are
often a staple of many people’s retirement portfolios.
How do you know if someone only has an insurance license and

nothing else? Easy, check out their business card. Someone with a
securities license will always have the name of their broker-dealer
in the small print of the card, most of the time starting with the
words “securities offered by”. Now, to make matters a bit more
complicated, someone can be a Registered Investment Advisor but
not have a broker-dealer.
To make it simple, follow this simple rule of thumb: If there is no

broker-dealer fine print on the bottom of the business card, ask the
person if they are a Registered Investment Advisor. If the answer
is no, then chances are very high that they only have an insurance
license.
Some of the best financial plans I’ve seen have come from insurance
advisors who do not hold securities licenses. Yes, there are a couple
of spectacular ones out there. In fact, in one chapter of this book I’ll
outline an income plan that doesn’t include any securities products,
and it’s easily one of the best income strategies around.
4. Have you checked out the financial advisor’s background?

Before you hire a financial advisor, verify his or her credentials
with the NASD. You can do this by visiting the NASD Web site at
www.nasd.com. When you get to the page that shows the financial
advisor’s information, you will see a section labeled “disclosure
events.” If this term is highlighted, the financial advisor may have
had legal problems related to his or her business or otherwise. If
you request additional information about the issue, the NASD will
mail it to you within 10 days.
5. Has the financial advisor explained risks and rewards?

There is no such thing as the perfect investment, and a good
financial advisor will explain that. Don’t agree to work with anyone
who has“the perfect investment”or doesn’t very clearly explain the
advantages and disadvantages of what he or she is recommending.
No disadvantages discussed? Then it’s simple – walk away.
6. How is the financial advisor paid?

Some financial advisors are paid by commission, that is, they take
a percentage of every transaction they make on your behalf. Some
are paid a fee, which is often a percentage of the assets they manage
for you each year. Some are paid by the hour. And some are paid by
a combination of commissions and fees. Be sure you know how the
financial advisor you are considering is going to be paid and how
much he or she charges. A good financial advisor will also explain
any additional fees, such as those you will pay for any load funds
that are purchased for you.
Generalizing which type of fee arrangement you should consider is

very difficult. Everyone’s situation is different. What might be right
for one could be entirely wrong for another. But understanding the
fee arrangement and how the advisor is getting paid is critical to
know before any commitments are made. More on this in the next
chapter.
Financial Designations
CFP – Certified Financial Planner
CFPs have obtained three years of financial planning experience, passed
several exams, and meet continuing education requirements. They
can offer a broad range of advice on financial planning, investments,
insurance, taxes, retirement planning, and estate planning.
CFA – Chartered Financial Analyst

CFAs have earned a college degree, completed at least three years of
study, been tested by the Association for Investment Management
and Research, and meet continuing education requirements. They are
generally money managers and stock analysts.
ChFC – Chartered Financial Consultant

ChFCs are typically life insurance agents who have completed
coursework in financial planning, passed an exam, and obtained three
years of financial planning experience. They generally provide all-
around financial planning with an emphasis on insurance.
CPA – Certified Public Accountant

CPAs are required to pass a rigorous national exam and meet
continuing education requirements. They can advise you on income
tax, investment and estate planning issues.
PFS – Personal Financial Specialist

PFSs are CPAs who have received accreditation from the American
Institute of Certified Public Accountants (AICPA). This accreditation
requires that a PFS prove financial planning experience, pass an exam,
and submit references every three years.
RIA – Registered Investment Advisor

RIAs are usually financial professionals, such as accountants and
insurance agents, who have registered with the Securities and Exchange
Commission (SEC) or individual states. The title does not constitute an
endorsement by either or require an adherence to a code of behavior.
RR – Registered Representative
RRs have passed a qualifying exam administered by the National
Association of Securities Dealers (NASD). They are generally sales
representatives for a brokerage firm. Their expertise is in selecting and
monitoring stocks, bonds, mutual funds, and other financial products.
Interviewing Your Next Financial Planner

Discuss fees as well as services
I believe that virtually anyone with a decent income can benefit from
the services of a financial planner, and by financial planner I don’t mean
a broker whose only interest is obtaining a commission on a financial
product. I’m referring to a professional who will assess every aspect
of your financial life – from savings to investments to insurance – and
help you develop a detailed strategy for meeting all of your financial
goals.
It’s usually easy to find financial planners in your area. You can look
through listings in the phone book or get recommendations from
friends and colleagues. But how do you know which one to hire?
Before deciding on a financial planner, you’ll want to interview several,

and you’ll want to ask all of them questions about their education
and experience. But most people know this. What’s more difficult is
interviewing financial planners about their investment approach and
fee arrangements – two subjects that may be closely tied together.
These two topics are more difficult to discuss because financial

planning services vary widely. Some planners offer only investment
advice, some offer estate planning, and others even do your taxes. The
fee structure that financial planners use to charge for their services
also varies widely. Some charge either a fixed or hourly fee for the time
it takes to develop your financial plan, but they don’t sell investment
products. Some simply receive commissions on the products they sell.
And still others are paid by a combination of fees and commissions.
When hiring a financial planner, then, it’s important to know in

advance exactly what services you think you’ll need and what services
the planner can deliver – and to ask how much those services cost,
as well as how the planner gets paid. For example, if you need a
comprehensive investment plan but are willing to invest your funds
yourself, a financial planner who charges by the hour may be your
best choice. After obtaining a clear understanding of your financial
goals and risk tolerance, the financial planner will develop an asset
allocation plan for you – that is, tell you how much of your money
you should have invested in different asset classes such as stocks and
bonds. He or she will then recommend some specific investments to
help you achieve that asset allocation, but you’ll do the actual investing
yourself.
On the other hand, if you already have a number of investments with

different firms, and you want a financial planner to manage your
money on an ongoing basis, and maybe even do some estate planning
for you, consider a planner whose fees are asset-based. In other words,
you pay the planner a percentage of the assets you have invested on
an annual basis, and the planner provides all the services you need.
In this case, it’s important to understand what you’re getting. Exactly
what services will the planner provide? How regularly will the planner
provide those services? Will you always be working with the planner
directly, or will other people be involved?
Finally, you’ll want to listen to how each financial planner answers

your questions. Does the planner seem genuinely interested in learning
more about your personal situation, such as your risk tolerance, before
making any recommendations? Does he or she clearly express that

there are no guarantees when it comes to investing? Remember,
you’re looking for someone who will tailor a financial plan for you
and won’t promise more than he or she can deliver. Forget about the
planners that make everything sound way too easy, such as getting you
returns of 12% per year without any problem. Those are just accidents
waiting to happen. If you don’t feel comfortable with a planner you’re
interviewing, for any reason, interview someone else. This is a person
you’ll ideally want to be working with for a long time to come.

Custodial Accounts and Trusts

Using them to avoid estate taxes
If you have an estate that is large enough, a share of what you would
like to leave to your heirs may go to the government in the form of
estate taxes when you die. But it doesn’t have to, if you know how to
make use of custodial accounts and trusts.
One way to avoid, or at least reduce estate taxes is to give away some
of your assets during your lifetime. However, when you give a gift,
you may be subject to paying gift taxes, which are levied on yearly
gifts valued at more than $12,000 per year per “giver”. But remember,
gifts in amounts up to $12,000 per year, per giver, are not taxed. So
if you and your spouse each transfer $12,000 annually (for a total of
$24,000 per year) to a custodial account for 15 years, at the end of
that time period you will have transferred $360,000 and saved over
$100,000 in income taxes (if you’re in the 28% tax bracket). Even better
for your heirs, if you invested that money, it will have grown to even
more. Suppose you invested that $24,000 once a year and received a
hypothetical annual return of 6%. That investment would be worth
$558,623 at the end of the 15 years.
One way to make a gift like this is through the use of a custodial
account, such as a Uniform Gift to Minors Act (UGMA) account
or Uniform Transfer to Minors Act (UTMA) account. Both of these
accounts are a type of trust set up for the benefit of a child. You can
open such an account at a bank or through a mutual fund company,
naming a custodian and contributing to the account. Then, when the
child reaches the age of maturity, he or she is entitled to take over
the account. Just to note: Technically speaking, once you’ve gifted the
money, you cannot take it back for your own use.
These accounts are well-suited to relatively small dollar amounts

because they’re easy to set up and relatively inexpensive to maintain.
However, there are some caveats to keep in mind when establishing
one.
First, don’t name yourself as the custodian of the account. If you do,
and you die before the account terminates, the money in it will be
included in your estate – exactly what you wanted to avoid! This is true
even though the transfers to the account have been completed. It’s
better to name someone as a custodian who will not make any gifts to
the account, such as an uncle or myself (just kidding).
Second of all, you may use the funds in the account for the child’s
benefit, but be careful. The Internal Revenue Service (IRS) contends that
if you are a parent setting up an account, you have a legal obligation to
support your child, so if it appears that you are using any of the money
in a UGMA/UTMA account to support the child instead of doing so
yourself, the IRS may claim that any income from the account will be
taxed to you, not to your child. In addition, there is little-established
guidance on this issue. Some tax experts argue that the UGMA/UTMA
law contains language designed to prevent parents from being taxed
on custodial account income when the account is used for purposes
that fall within the parent’s support obligation. Others say the law is
unclear. So be forewarned that this may be an issue.
You can avoid any possibility of these problems, and many others,
by establishing a trust instead of a custodial account. Yes, there are
additional costs involved, but they may be less than you expect. And
if you’re dealing with a large sum of money, the advantages may far
outweigh the cost. Discussing your plans with a financial advisor will
help you to more fully understand your options.
Employer-Sponsored Retirement Plans

Should you roll yours into an IRA?
Around 47 million Americans are participating in qualified employer-
sponsored retirement plans. Undoubtedly, these people think they’re
taking control of their financial future by investing in a 401(k), 403(b),
or government 457 plan. But are they?
Employer-sponsored retirement plans are a great way to save for

retirement. However, a problem arises when you keep accounts with
several past employers. Holding your accounts in many different places
can make it difficult to manage your investments effectively as your
goals, and the markets, change.
Whenever I encounter people in this situation, I often suggest that

they take control of their retirement assets by moving them from those
employment accounts to a rollover individual retirement account
(IRA). Here are three reasons why:
1. A rollover IRA may provide better investment options.

Some people feel that keeping retirement plans with several
different employers is a good way to diversify their investments. In
reality, most employer-sponsored retirement plans offer very limited
investment options. That limitation could put your retirement
savings at risk, particularly if your savings are concentrated in just a
few funds or your employer’s stock. In contrast, rollover IRAs offer
a variety of investment options, allowing you to better allocate your
retirement funds according to your personal investment goals.
On the flip side of this, every once in a while I meet a person

who has money in an employer’s retirement plan with a rate that
absolutely cannot be found anywhere else. For example, the New
York Teacher’s Union (at the time of this writing) still maintains a
fixed account that pays better than 7% per year. A fixed interest
rate such as that is impossible to find anywhere else, and it’s for
this reason I would tell those people not to roll their money into an
IRA because they’ll never (again, at time of this writing) be able to
replace it in a rollover, self-directed IRA. It’s sad to think there are
financial advisors out there trying to roll this money into an IRA for
their own benefit, not the client’s.
With that said, it’s very rare that I see an instance where someone
cannot at least equal the returns they are getting in their employer-
sponsored account, but it’s important to consider.
2. It can be difficult to manage investments spread between multiple

retirement plans.
If you have more than one retirement account, consolidating your
retirement assets into a single rollover IRA can make managing
them easier. There will be considerably less paperwork, which will
aid in tracking your investments. Additionally, keeping retirement
assets in one place simplifies beneficiary designations and estate
planning.
3. The mutual funds available through your current retirement plan

may have high expense ratios.
A small savings of even half a percentage point in mutual fund
expenses can mean thousands of dollars more in your pocket
over a few years. If you’d like to see a demonstration, try using
the mutual fund cost calculator available from the Securities and
Exchange Commission (SEC). Just go to www.sec.gov and click on
“Calculators for Investors” under “Investor Information.”
Note that when you request a direct rollover into an IRA, no money
is actually distributed to you; it moves straight into the IRA. As
a result, you’re not taxed (until you withdraw the money later),
and 100% of your retirement assets can continue to grow tax-
deferred.
Keep in mind that moving assets into a rollover IRA isn’t always
the best choice. For example, if you have a retirement account with
just one employer, and you have numerous investment options
and pay low fees, it might make sense to leave your retirement
assets where they are. Should you decide that moving your assets
into a rollover IRA is right for you, check with the company’s
retirement plan administrator (who is typically part of the benefits
or human resources department) to determine whether there are
any restrictions on rollovers before you do so.
If you have a retirement plan with a current employer, you may not
be able to roll over assets from that plan into an IRA. Most retirement
plans restrict rollovers while you are employed by the company
that offers the plan. In addition, if any part of your retirement plan
investment with your current employer is held in company stock,
you’ll need to find out if the plan has any restrictions on selling your
shares, again, by contacting the retirement plan administrator.
Finally, when you’re ready to move your assets, be sure to contact

a financial advisor. Many rollover IRAs are available, and a
professional can help you select one that best fits your long-term
investment needs.
Year-End Checklist
The top 10 money matters you don’t want to miss
Wait! Hold off for a minute. Don’t drink that champagne and sing
“Auld Lang Syne”yet. It’s not too late. As the holidays approach, many
people vow to get their finances in order, but few actually do so. If
you’re a procrastinator, here are 10 last-minute tips to help ensure
that you take at least some steps toward improving the state of your
finances by the end of the year. So before popping the cork and kissing
your significant other, take a moment to mull over these thoughts that
could have a significant impact on your financial well-being.
1. Take your required minimum distributions (RMDs).

If you’re an individual retirement account (IRA) owner age 70½
or older, and you haven’t taken your RMDs for the year, you need
to do so by the end of the calendar year. Internal Revenue Service
(IRS) Code regulations require that you take initial withdrawals
from traditional, Simplified Employee Pension Plan (SEP) and
Savings Incentive Matching Plan for Employees (SIMPLE) IRAs
by April 1 in the calendar year following the year you reach age
70½ and each year thereafter. Then, on an ongoing basis, you must
withdraw the remainder of the total RMD amount for each year
by the end of that calendar year. For example, if you reached age
70½ in 2005, your first withdrawal must be made by April 1, 2006,
and you must take the rest of your total 2006 RMD for the year
by December 31, 2006. If your RMD is not taken in what the IRS
considers to be a timely manner, you may be assessed a 50% excise
tax on the amount you should have withdrawn. Ouch!
2. Spend the balance of your Flexible Spending Account (FSA).

If you participate in an FSA for either health or dependent care,
check to see if the plan has implemented the new 2½ month
extension provision, which allows 2006 FSA money to be used for
expenditures through March 15, 2007. If the plan doesn’t have the
extension, be sure to use up any balances before the end of the
calendar year or they will be forfeited. One way to do so: Stock up
on over-the-counter medicines for next year.
3. Make last-minute charitable contributions.

Maximize itemized deductions by making donations in the form
of cash, property, or appreciated stock. The latter helps you avoid
capital gains taxes too.
4. Make an extra mortgage payment.

Making that one extra payment will, over time, cut the amount
of interest you’re paying on your mortgage and actually reduce
the number of years you’ll need to make payments before your
house is free and clear. It will also help you maximize itemized
deductions. This could make a tremendous difference in your long-
range plans.
5. Consider making deductible business purchases by the end

of the year.
If you’re self-employed, and know you’ll need to buy deductible
business-related items in the following year, you may want to buy
them now to maximize your deductions in the current year (and
take advantage of holiday sales).
6. Think about gifting.

At the time of this writing, you can gift up to a total of $11,000 per
year (per person) to as many people as you want. That $11,000 may
be given to one person, or distributed to any number of individuals.
Your taxable income will be reduced by the amount that you gift.
7. Review and balance your capital gains and losses.

Make note of capital gains you’ve realized this year from the sale
of stocks or mutual funds. Also find out if any of your mutual funds
will be distributing capital gains. When you’ve added up your gains,
check to see if there are any losses you can carry forward from
previous years to offset these gains. If there aren’t, consider selling
under-performing securities. Taxes should never be the sole reason
you buy or sell investments, but it may be possible to improve your
tax and your investment situations at the same time. Think of it as
being a good time to “clean out the closet”.
8. Consider increasing your final 401(k) contribution.

If you haven’t already contributed the maximum of $14,000
($18,000 for those 50 and older) to your 401(k), consider increasing
your contribution amount from your final paycheck. You have until
December 31 to make your final contribution for the year. (Note:
All figures are at the time of this writing. Check resources such as
www.irs.gov for current information.)
9. Open and fund a 529 plan college savings account.

A 529 plan account offers high maximum contribution limits and
significant tax benefits. Money in the account can grow tax-free
for years. And, withdrawals are tax-free if used for any number of
expenses related to higher education. But some people are using
them for estate planning as well, since the money you put into
a 529 plan account is considered a “gift”. You’re allowed to
contribute up to $55,000 – which is considered five years’ worth
of gifting – at one time. The rule is based on a calendar year, so
if you make a contribution in December, one of the five years (or
$11,000) is applied to the current year. The balance of your gift will
carry over and be credited in subsequent years ($11,000 per year).
10. Make your IRA contributions.

You can make IRA contributions through April 17th, but why not
consider doing it now so you don’t forget? The IRA contribution
limit for 2007 is $4,000, and $5,000 if the person is age 50 and
over.
One last very important point: I have known many people

– especially business owners (sole proprietor, C Corporation, S
Corporation, and others) – who amazingly have not set up programs
such as Keoghs, SIMPLE IRAs, 401(k)s, etc. What a shame! The
ability to “take income off the top” and place it into a qualified
plan is a true misfortune. With enough time until the end of the
year, it is still possible to set up a qualified plan. I cannot stress
this enough: If you have no qualified plan for your business, you
absolutely, positively need to make inquiries as to whether or not
you can and which one is best for you. Speak to your accountant or
a financial advisor. This could be the best thing you do for yourself
before popping the cork!
Will Your Well Run Dry?

Preparing for retirement
Baby boomers – those of us born between 1946 and 1964 – are in a
predicament. We’re getting ready to retire, and most of us won’t be able
to afford it. In days past, when people retired they had approximately
70% of their annual pre-retirement income to live on. It was that simple,
thanks to employers managing retirement plans.
Today the responsibility for retirement planning has shifted from

employer to the employee. Gone are most pension plans; these days,
most people have 401(k) plans. You, the employee, must decide how
much you’ll contribute and how you’ll invest that money. If there
isn’t enough in your well at retirement, you’ll have to “rely” on Social
Security.
So what’s the problem? The Social Security well may also run dry soon.
Baby boomers – more than 77 million strong – will start becoming
eligible for Social Security benefits in 2008. But if there’s a federal
budget deficit, as there is today, the government could be forced to
delay benefits or even cut them, a once improbable possibility that
previous Federal Reserve Chairman Alan Greenspan warned of

somewhat recently.
That’s all bad news, because according to the Employee Benefits

Research Institute, the average person in his 60’s had a balance of
$105,822 in his 401(k) at the end of 2001. What does that mean?
Most people entering retirement seem to be planning to rely almost
exclusively on Social Security for their retirement income. And how far
will that go?
While people can be advised to plan better and save more, even that
isn’t always enough. The answer may seem obvious, but conventional
wisdom and logic doesn’t always hold true.
To illustrate the point, consider Joe, a hypothetical 24-year-old who

starts planning for retirement now and does everything “right”. Joe
has a good job, with a salary of $35,000. He gets 6% raises each year,
and he contributes 10% of his salary to his 401(k) plan every year.
Joe’s also lucky with his investments: They return a solid 8% annually
during his working years, and later, 5% per year after Joe retires. When
our hypothetical worker reaches age 59½, he’ll be earning $253,785 a
year and his 401(k) balance will be $1.24 million. He’s set, right? Not
quite. Joe will need 70% of his salary – $177,650 per year – when he
retires just to maintain his pre-retirement standard of living. Assuming
he gets the maximum Social Security payment of $45,000 ($10,800 in
today’s dollars, with a 3% annual increase for inflation), he’ll still have
to withdraw $132,650 a year from his nest egg. And at that rate, he’ll
be out of money by his 69th birthday!
Many of you will think about this man’s situation and say that his
problem is easy to solve. All Joe has to do is change his asset allocation
so he can potentially earn more on the money he saves. But that strategy
may not be as helpful as it was once thought to be. According to the
popular T. Rowe Price Retirement Income Calculator www.troweprice.
com, if someone who has $600,000 in savings and a life expectancy of
25 years at retirement withdraws 5% per month, he has only a 50%
chance of meeting his retirement goals – even if he puts 90% of his
money in equities. Sounds depressing, doesn’t it?
So how can you solve the problem? How can you safely obtain
significantly more income for yourself at retirement without sacrificing
a future inheritance to your heirs? Several interesting solutions exist,
and we’ll analyze one of my personal favorites in a few chapters to
come. (Hint: Pay attention to Chapter 3’s “peanut butter and jelly”.)
TWO
INVESTING CHAPTER 41
The Benefits of Diversification

Balance and portfolio stability
There are several aspects involved in successful investing. The first, of
course, is asset allocation, or determining how much of your money
belongs in each asset class – equities, debt instruments, and cash
equivalents. Then there is selecting specific investments, meaning
individual stocks or bonds, mutual funds, money market accounts,
etc. The third aspect of successful investing involves monitoring and
evaluating the performance of the investments you hold in your
portfolio, followed by making any necessary adjustments, either
by selling poor performers, buying potential profit-makers, or just
rebalancing your holdings.
We’ll start with allocating your assets and diversifying your portfolio.
Most investors have heard of diversification and many can explain
why it’s important, but I often find that many don’t follow their own
advice. So let’s review one of the most important fundamentals of
smart, sound investing.
42 INVESTING
Different asset classes – such as domestic stocks, international stocks,

bonds, real estate, commodities, and cash equivalents (i.e., money
market accounts) – perform differently in different markets. In other
words, they’re usually uncorrelated. While some asset classes may be
in favor and more profitable, others may be out of favor at the same
time. Allocating your assets involves dividing up your investment funds
among these classes. Diversification is simply the process of spreading
your investments across multiple asset classes so that your invested
dollars are not solely dependent on the performance of any one asset
class. While diversification doesn’t eliminate the risk of loss, it can help
you better manage the effects of market volatility on your portfolio.
Rather than trying to guess which part of the market will be up and
which part will be down in any given period, a diversified portfolio will
almost always reduce the risk and stabilize your return over time.
As evidence, if you look at a number of asset classes over the past

10 years – large-cap value stocks, large-cap growth stocks, small-cap
value stocks, small-cap growth stocks, international stocks, real estate,
commodities, and bonds – the best and worst performers have varied
every year, as shown in the chart. Asset allocation can be thought of
as a strategy for assisting you in achieving sensible diversification.
Investors often think of a traditional asset allocation as 60% stocks and
40% bonds, but it doesn’t stop there. You will also want to spread your
investments among different sectors (i.e., health care and technology),
companies with varying sizes of market capitalizations, and domestic
and international categories.
Consider the performance of this hypothetical diversified portfolio:

An unmanaged combination of indices representing 40% bonds, 15%
large-cap growth stocks, 15% large-cap value stocks, 10% international
stocks, 5% real estate, 5% small-cap growth stocks, 5% small-cap
value stocks, and 5% commodities. A portfolio invested in this manner
would have returned 22.06% in 2003, 11.67% in 2004, and 8.81% in
2005.
INVESTIN G 43
Year Best Performer Worst Performer
1995 Large-cap value stocks, 38.35% International stocks, 11.21%

1996 Real estate, 37.04% Bonds, 3.63%
1997 Large-cap value stocks, 35.20% Commodities, –14.08%
1998 Large-cap growth stocks, 38.70% Commodities, –35.73%
1999 Small-cap growth stocks, 43.10% Real estate, –2.57%
2000 Commodities, 49.73% Small-cap growth stocks, –22.44%
2001 Small-cap value stocks, 14.02% Commodities, –31.91%
2002 Commodities, 32.02% Small-cap growth stocks, –30.26%
2003 Small-cap growth stocks, 48.54% Bonds, 4.10%
2004 Real estate, 33.82% Bonds, 4.34%
2005 Commodities, 25.55% Bonds, 2.43%
With all those asset classes to choose from, however, allocation

isn’t quite as simple as it sounds. Many investors make the mistake
of being too conservative in their asset allocation. As you approach
your investment goal – be it the purchase of a home or retirement, for
example – of course you’ll want to take fewer risks with your money.You
may allocate more money to bonds and cash, and less to international
stocks and commodities. But you need to realize that it’s still important
to maintain an allocation to what are traditionally considered to be
more risky investments because they also bring the greatest potential
for reward. If you allocate too little to stocks, your portfolio probably
won’t grow enough to significantly outpace inflation. Just look at the
chart and see in how many of the past 10 years bonds were the worst
performers.
Another asset allocation mistake is failing to rebalance your portfolio

regularly. You’ve probably heard of this concept before, that of “re-
balancing,” and either ignored it or didn’t understand it. But suffice it
to say, it’s one of the most important concepts you can ever implement
in a portfolio. Why? Well, what’s the single most desirable situation in
investing? Selling high and buying low, correct? How do you do that?
Easy – through rebalancing.
44 INVESTING
Let’s say that you and your financial advisor agree that a 60% equity/40%
income split is appropriate for your circumstances and your portfolio
is balanced accordingly. Over time, two things can happen.
First, your needs may change. Perhaps your tax liability has increased
and you want to consider tax-exempt investments, or you’re ready to
start taking income from your portfolio. Second, even if your needs
have remained the same, your portfolio probably won’t stay balanced.
Strength in the stock market could cause your equity holdings to
swell way beyond 60%, or a disappointing performance in income
investments could cause your income holdings to shrink to less than
40%. You’ll need to assess these factors and buy or sell securities as
needed to stay on track with your asset allocation.
So suppose your target allocation is 60% stocks and 40% bonds. For
this brief chapter, I’ll keep this pretty simple, but the overall concept
is very effective. Now, let’s say within that 60% stocks category, there
are several “sub-classes”, one of which is in technology. And let’s say
it’s the 90’s, and tech is surging beyond our wildest dreams. You wake
up and find the portfolio is now 80% stocks (mostly because of tech
in this example). What happens to bonds during this bull run? They
usually fall in value. So now you have 80% stock, 20% bonds. If you
follow a rebalancing strategy, what happens? You rebalance so that
you sell off 20% of those heated stocks at a high (for a profit), and
reallocating that 20% into bonds, right? And what happens when you
invest that 20% into bonds? You are buying at a low. That’s precisely
what every investor dreams of, and with rebalancing – I kid you not
– it really can be that simple.
If you’ve had the unfortunate experience of incurring significant losses

in the markets, it was most likely the result of a poorly structured
portfolio that was too heavily “weighted” in one sector. Those who
invested too heavily in technology during the bust of 2001-2002 can
probably vouch for that. To avoid market disasters, don’t ever weight
your portfolio too heavily in any one sector, diversify among the
INVESTIN G 45
standard asset classes, and make sure to rebalance your portfolio at

least once a year. (I personally do so once or twice a year, but certain
market conditions may prompt me do it more or less often.)
Following these simple rules will most certainly provide you with
significantly better chances for long-term investment success.
46 INVESTING
The Index Advantage

and Exchange-Traded Funds
Play the market with less cost and risk
Mutual funds, which offer professional stock selection and
diversification, are popular investment options today. But they aren’t
always what they’re cracked up to be, thanks to high management fees
and excessive trading activity (which can result in capital gains taxes).
What if you could reap the benefits of mutual fund investing without
the associated costs? Well, you can – with an index fund.
An index is a group of stocks selected to represent a certain portion

of the stock market. The Standard & Poor’s (S&P) 500 Index, which
consists of 500 large-capitalization (large-cap) domestic stocks,
such as Microsoft and General Electric, is widely considered to be
representative of the market as a whole. The Russell 2000 Index
consists of small-capitalization stocks. The Morgan Stanley Capital
International Europe, Australasia, Far East (MSCI EAFE) Index holds
international stocks. You will find that there’s an index for just about
every segment of the market, including specialized segments, such as
INVESTIN G 47
health care stocks and real estate investment trusts (REITs). There are
even indices for Genome companies, water companies, biotechnology,
oil exploration, etc.
An index fund invests in the stocks that make up a specific index. An

S&P 500 index fund, then, would try to replicate, as closely as possible,
the allocations to stocks found in the S&P 500. When you match the
investments in an index, you also match the return of that index – and
that’s something most mutual funds can’t do. According to investor
information sources such as the Wall Street Journal, Motley Fool, and
many, many others, less than 20% of actively managed, diversified,
large-cap mutual funds have outperformed the S&P 500 over the last 10
years. Part of the problem is stock selection; managers make mistakes
and trade on emotion. But another big factor is fees and expenses.
Index funds invest in whichever stocks are in a particular index, in

the same allocations. They don’t hire analysts with Ivy League MBAs,
and they usually don’t develop a lot of slick marketing materials to
convince you that their fund is the best. This significantly reduces the
operating fees the fund must charge shareholders, which leaves more
of your money to grow.
Moreover, actively traded mutual funds do just that, actively trade.

And when a mutual fund sells stocks, the capital gains (or losses) are
passed on to you, meaning you have to pay taxes even though you
haven’t sold anything. Typically, trading is only done within an index
fund when the composition of the index it represents changes. The
result is much less of a tax bill for you, given the fact that these changes
are usually quite infrequent.
There are two main ways to invest in indices: Through index mutual
funds and through exchange-traded funds (ETFs). Both types of funds
replicate an index. Index mutual funds, as the name implies, are mutual
funds. You obtain them through your financial advisor or any mutual
fund company that sells directly to the public. ETFs, on the other hand,
are bought and sold like regular stocks, and even have stock symbols.
ETFs that track the S&P 500 include Spiders (SPY) and iShares (IVV is
48 INVESTING
one example). One thing you’ll want to watch out for, whichever you
choose, is the fees. Before you invest, check the index mutual fund’s or
ETF’s expense ratio, which is calculated as a percentage of the amount
you invest. Generally, don’t invest in an index fund or ETF with an
expense ratio greater than 0.40.
As for performance, the returns on index funds and ETFs are almost
identical. But there are a few reasons you may want to consider one
over the other. Since ETFs are bought and sold just like stocks, you’ll
probably pay a commission each time you buy and sell. So if you are
systematically investing on a monthly basis, you would likely be better
off purchasing the index as a mutual fund instead of an ETF (given
that most index mutual funds will not charge you fees when adding
more money). One distinct advantage ETFs have, however, is that they
can be traded on a moment’s notice – “intraday” – whereas shares of
a mutual fund don’t actually get sold until the end of the day. Finally,
because an ETF trades like a stock, it offers yet another significant
advantage: being able to set a “stop loss” that could potentially protect
you by automatically cutting your losses at a predetermined dollar
amount when the related index falls.
So should you invest in an index mutual fund or an exchange-traded

index fund? My bet has always been in favor of index exchange-traded
funds. But as with any investment, make sure you understand all the
facts before jumping in.
INVESTIN G 49
Small Company Stocks

Providing big results and portfolio balance
Small-capitalization (small-cap) stocks, which typically lead the market
as the economy comes out of a downturn, finished near the top of
the performance charts in 2004. The Russell 2000 Index – the index
that is used as a benchmark for small-cap performance – returned
18.33% that year. As a result, many investors are asking if they should
move more of their portfolio into this asset class. But that’s not an easy
question to answer.
What exactly is a small-cap stock? If you’re considering small-cap

stocks, it’s important to understand what they are. Simply put, they’re
stocks of companies that have a relatively small market capitalization
– market capitalization being the total dollar value of all outstanding
shares of a company’s stock.
There are many reasons to invest in small-cap stocks. For one, smaller
companies tend to provide products and services for the domestic
market, so they may be less affected by economic disturbances abroad.
Secondly, their size can allow them to react more quickly to changes in
50 INVESTING
the economy than larger companies can (which explains why small-cap
stocks have traditionally performed well as the economy is emerging
from a downturn). And thirdly, they have room to grow.
That said, small-cap stocks aren’t for everyone. Typically, the smaller the
stock, the more risk it presents. Why? Because the management may
be less experienced. Business risks, such as shrinking product demand,
may be accentuated in smaller companies. Because it can be harder to
find buyers for these stocks, it may take some time to sell your shares
when the economy or markets perform poorly. But keep in mind that
as of the latest reconstitution of the Russell 2000 Index, the average
market capitalization of a company in the index was approximately
$607.1 million. A business of that size isn’t exactly a mom-and-pop
shop either.
Overall, I like small-cap stocks. And their tendency to perform well

when others asset classes are not is one of the reasons why. Investing
in small-caps helps provide your portfolio with diversification. Just
take a look at the chart for more evidence.
So, if you can handle the risks, I think it’s a good idea to add some
small-cap stocks to your portfolio. How much will depend on various
factors, including your time horizon. A financial advisor can help you
determine what amount may be appropriate for you to invest.
And lastly, if you’re going to add small-cap stocks to your holdings, I

recommend that you do so by investing in a variety of small-caps to
further diversify this component of your portfolio. You can do this by
selecting individual stocks, or you can purchase shares of a mutual
fund that invests specifically in small-cap stocks.
INVESTIN G 51
Market as a Large-Cap Stocks: Small-Cap

Year Whole: Russell Stocks: Russell
S&P 500 Index 1000 Index 2000 Index
1993 10.06% 10.15% 18.90%

1994 1.32% 0.38% - 1.82%
1995 37.58% 37.77% 23.34%
1996 22.96% 22.45% 16.49%
1997 33.36% 32.85% 22.36%
1998 28.57% 27.02% - 2.55%
1999 21.05% 20.92% 21.26%
2000 - 9.10% - 7.80% - 3.02%
2001 - 11.88% - 12.46% 2.48%
2002 - 22.09% - 21.65% - 20.48%
2003 28.67% 29.90% 47.25%
2004 10.87% 11.40% 18.33%
Index returns assume reinvestment of dividends and capital gains, and

unlike fund returns, do not reflect fees or expenses. You cannot invest
directly in the index. During the periods discussed, a number of index
stocks could have had significantly negative performance. Therefore,
it is possible for index performance to be positively influenced by a
relatively small number of stocks.
52 INVESTING
Real Estate Investment Trusts

Is the boom over?
Real estate investment trusts (REITs) have had an incredible run. For
the past five years or so, they’ve earned investors 20.37% per year, as
measured by the Morgan Stanley Capital International (MSCI) U.S.
REIT Index. But many analysts are predicting that the future for REITs
isn’t so bright. With that said, should you invest in them?
First, let’s make sure you clearly understand what constitutes a REIT.
A REIT is a security that invests directly in real estate, either through
properties or mortgages. You can buy or sell a REIT just like you would
a stock on the major stock exchanges. At the time of this writing, one
of the best-known REITs is Equity Office Properties (EOP). Other
popular REITs, all traded on the New York Stock Exchange (NYSE),
include BioMed Realty Trust (BMR), Boston Properties (BXP), Prentiss
Properties (PP), and Trizec Properties (TRZ).
INVESTIN G 53
Like most securities, REITs have historically experienced cyclical ups

and downs. Typically, they have performed poorly when interest rates
have risen. But the past year-and-a-half has been an exception. Despite
interest rates rising, the returns on REITs have been up – 17.74% over
the past year – as measured, again, by the MSCI U.S. REIT Index.

Some analysts think that REITs are going to continue to perform
well. In a recent issue of the National Association of REITs’ Real Estate
Portfolio, for example, the CEO of Vornado Realty Trust, Steven Roth,
who has 40 years of experience in the business, proclaimed income-
producing real estate to be in “a secular bull market – emphasis on
secular”.
Other analysts, however, are predicting doom and gloom for the asset
class.You’ve probably heard rumblings about a“real estate bubble,”and
Mike Swanson, an analyst who produces a weekly newsletter called
Wall Street Window, says “the REIT bubble is about to burst”. For those
of you who agree with this outlook, ProFunds has an interesting fund
that will rise in value if the U.S. Real Estate Index falls. Check it out
at www.profunds.com, and as with any investment, be sure to read the
prospectus carefully before investing.
If indeed the real estate market does go down, that shouldn’t necess-
arily worry potential investors. You can still gain the benefits of REITs
while minimizing your risk in a number of ways. First, you can invest
in REITs in certain sectors. For example, REITs that focus on retail and
self-storage have been performing well. On the other hand, REITs that
focus on offices and apartments have been struggling, perhaps because
the U.S. economy’s recent recovery has focused on the consumer.
It’s also important to consider the quality of a REIT’s management,

tenants, and underlying properties. BioMed Realty Trust, for instance,
specializes in leasing lab space to tenants such as biotechnology and
pharmaceutical companies. If you believe that there will be growth in
the health care sector, it may also follow that BioMed Realty Trust will
do well.
54 INVESTING
Regardless of which asset class or REIT sector you’re looking at, you
always want to buy out-of-favor companies with good potential
to generate cash. That’s a basic principle of investing. Yet as with
all investments, there are no guarantees. So if you’re interested in
investing in a REIT, be sure to consult with a financial advisor who
can help you select a REIT that best fits your desired level of risk to
reward.
With all this in mind, be sure to recall a very important previous

chapter: That on diversification and the importance of rebalancing. A
well-diversified portfolio, as far as I am concerned, should always have
exposure to real estate, and for that reason, an investment in a REIT
always plays a role in a balanced portfolio.
INVESTIN G 55
Evaluating Performance
Using market indices
One pacesetter that investors often turn to when evaluating the
performance of their investments is an index, such as the Standard &
Poor’s (S&P) 500 or the Dow Jones Industrial Average. What they may
not realize, however, is that these indices represent only a small slice
of the market, and they may not be relevant as a comparison for their
investments.
The S&P 500 is a good example. It’s designed to be a broad indicator of

stock price movement and is the most commonly used benchmark for
stock fund performance. The index consists of 500 leading companies
in major industries, chosen to represent the American economy. That
may seem like a big field until you consider that there are more than
5,000 stocks listed on the New York Stock Exchange, and the S&P 500
tracks only a small percentage of the stocks on the market. Moreover,
the S&P 500 consists of essentially one asset class: Large-capitalization
(large-cap) companies.
56 INVESTING
Market capitalization, a measure of a company’s size, is the total dollar

value of all outstanding shares of a company’s stock. Stocks with a
relatively large market capitalization are considered large-cap stocks.
Because the S&P 500 is limited to 500 of these companies, smaller
companies – which can drive U.S. economic expansion – are excluded
from the S&P 500. So if you have a small-capitalization (small-cap)
stock or fund, comparing it to the S&P 500 may not be an accurate
gauge of its performance.
Even for large-cap stocks and funds, the S&P 500 isn’t always an
accurate benchmark. That’s because the index isn’t equally weighted:
The largest and often most popular stocks have a weighting several
hundred times that of the less popular stocks, and thus account for the
majority of the index’s performance. In fact, in a bull market year, the
strength of just a few popular stocks can boost the S&P 500’s return
significantly. That’s just what happened in 1998, for example. The
index’s stated weighted return was 28.6%, but the average S&P 500
stock gained just a little more than half that – 15%.
That doesn’t mean you should ignore the S&P 500 and other indices.
The challenge is in finding the right index to use as a benchmark, and
understanding that differences in performance between your stock or
fund and the index may be explained by differences in your stock or
the composition of your fund versus the index.
Information about which index is used as a benchmark by a stock or

fund’s portfolio managers can typically can be found in the performance
section of their annual and semi-annual reports. But of course it’s not
just the S&P 500 Index that’s used as a performance benchmark. A few
of the other indices you may see listed include:
INVESTIN G 57
Russell 1000 Growth Index

Measures 1,000 large-cap growth stocks
Russell 1000 Value Index

Measures 1,000 large-cap value stocks
Russell 2000 Index

Measures 2,000 small-cap growth stocks
Russell 3000 Index

Measures the performance of the 3,000 largest U.S. companies
based on total market capitalization
MSCI EAFE Index

Measures the performance of the developed stock markets of
Europe, Australasia, and the Far East
Lehman Brothers Aggregate Bond Index

Measures U.S. government, corporate, and mortgage-backed
securities with maturities of up to 30 years
58 INVESTING
Portfolio Rebalancing
A declining market presents good opportunities
With the domestic stock decline in May 2006 (the time of this writing),
it seems increasingly likely that the market is headed for a correction,
which is defined as a 10% drop. While most investors view that as bad
news, it does present some opportunities. One of them is the chance
to rebalance your portfolio, and perhaps buy stocks at lower prices.
Most financial advisors agree that setting asset allocation targets

and occasionally rebalancing your portfolio as part of investment
maintenance is a good idea. But different advisors recommend different
time frames for rebalancing. On one end of the spectrum, some say
you should do it every month. On the opposite end of the spectrum,
others say you should do it every few years. I take the middle ground
and say you should rebalance whenever changing circumstances make
it necessary.
INVESTING 59
There are any number of circumstances that could prompt you to take
another look at your portfolio. As you move through life, meeting some
goals and creating new ones, your financial needs will change. Perhaps
your tax liability has increased and you want to consider tax-exempt
investments. Perhaps you’re ready to start taking income from your
portfolio. Or perhaps your threshold for risk has increased and you’re
ready to add more investments with higher reward potential.
The changing circumstances of the market can also affect your portfolio.
For example, let’s say that a 60% equity/40% income split is appropriate
for your circumstances, and you set up your portfolio accordingly.
Over time, your portfolio probably won’t stay balanced in that manner.
Strength in growth stocks could cause your equity holdings to swell
beyond 60%, or a disappointing performance in income investments
may shrink your income holdings to less than the optimum 40% you
had started with. This was covered in a previous chapter, however it is
so important that I cannot help but remind you here.
You may specifically want to take a look at your international asset

allocation. Over the past few years, international stocks – particularly
those of emerging market countries – have gained substantially. It’s
likely that these stocks now make up a greater percentage of your
portfolio than they ideally should, and that could increase your
overall risk.
It can be hard to sell a stock or mutual fund when it’s performing

well. Year-to-date gains in many international markets, for instance,
already exceed 20%. “Why not hold onto the stock and realize even
more gains?” you might ask. But remember, it’s almost impossible to
accurately predict market movements. You could miss an upturn, but
you could also fall victim to a downturn. Price-to-earnings (P/E) ratios
for many international stocks now exceed those of their more stable
domestic counterparts – not a good sign. And if international stocks
take a nosedive, they could do so quickly.
60 INVESTING
If you do sell some of your investments, you’ll want to replace them

– and a market downturn presents a good opportunity to find some
bargains. Technology stocks haven’t been doing well lately. Consider,
for example, eBay and Yahoo!, which hit 52-week lows in April 2006,
and are trading at P/E ratios not seen in years. A strategy of shopping
for investment bargains even helps you ride out market volatility with
some peace of mind. Instead of fretting about how much your holdings
have declined, why not make a shopping list of asset classes that
interest you, and watch to see how much cheaper they’re becoming?
You may decide that a couple of them are worth picking up.
Keep in mind that you shouldn’t buy a stock just because it’s cheap;
it should fit into your overall financial plan. I recommend consulting
with a financial advisor every few years at least, not only to develop an
asset allocation plan, but to make sure you’re on track.
INVESTIN G 61
6 Things Dating Teaches

Us About Money
Bad date last night? Don’t despair. It’s not as bad as you may think.
Here’s some good news: You may not know it, but when it comes to
your money, that bad date can teach you an awful lot about successful
investing.
Think I’m joking? Think again. Although I was a far cry from being
the King of Dating, I did have a few occasional lucky streaks in me.
And looking back over those rare few times, my moderate success
on the dating circuit did teach me quite a few things about prudent
investing.
Here’s a few quick examples…
1. Don’t judge a book by its cover

Dating: The guy was over a half-hour late, his outdated shirt barely
matched his Taco Bell stained pants, the rain gave him a lethal dose
of bed-head and back then the busboy was making more than he
was. If that wasn’t bad enough, his humor was a bit stale and the
62 INVESTING
car he drove had a weird putter that attracted nothing but aliens
from the evil Planet X. While at first the girl thought it was going to
be a dinner date from fiery hell, little did she realize that guy was I,
and I’d soon wind up being the one she’d marry.
Investing: The receptionist was sure nice, but the carpets were
dull and the musty furniture reminded you of grandma’s place
in Brooklyn. You were ready to take your money to that Private
Wealth Management Firm – the one with the white marble staircase
and baby grand – but when the well-mannered financial advisor
appeared, you figured you’d be courteous and give him a few
minutes of time. A little into his pitch, you were most pleasantly
surprised when he touted low cost, tax efficient investments with
attractive rates of return that perfectly matched your goals. It was
then you realized there’s a reason the furniture in his place is a bit
out-dated, mainly, because the guy most certainly isn’t paying for
it out of your own pocket.
Lesson Learned: First impressions can easily get the best of us.
Whether it’s a date or your money, taking a step back to peek
behind the curtain will typically put both your money and heart in
a much better place.
2. Costs count
Dating: She liked Dylan Thomas, idolized Ginsberg, despised
the conformists and was clinically depressed that she missed last
year’s Monterey Pop Music Festival. The perfect 10 from down in
the Village strummed an acoustic, wrote poetry and even donated
your favorite Levis to a homeless guy on the street. While at first
lust got the best of you, months after helping her pay the rent, her
organic meals and for all those Andy Warhol movies you pretended
to like, you were finally worn out, leading you realize that when it
comes to dating, costs most definitely do count.
Investing: The mutual fund was barely moving. Five years into it,
you just couldn’t quite figure out why you weren’t making much
money. Then, one fine day, you wisely took the time to research the
INVESTIN G 63
fees you were paying, only to realize the fund was charging you
well over 5% per year in annual costs and causing you all sorts of
taxes.
Lesson Learned: When it comes to investing and dating, costs

most definitely do count. Taking the time to evaluate how much
you’re paying for your dates and funds is an essential part of
anyone’s success.
3. It doesn’t have to be complicated for it to be effective

Dating: For many people, the best dates are the simple ones such
as times spent on the couch during a cold winter night, wearing
soft flannel pajamas under a fluffy blanket watching a classic
Bogart movie with, of course, hot green tea and a hearty bag of
Fritos nearby. While dining at Nobu certainly has its place in time,
looking back on all the great dates we’ve had most likely reminds
us it’s the simple ones that scored the most.
Investing: When it comes to investing, many of the most successful

investors I’ve helped are those with the simplest portfolios. On the
other end of the spectrum are investors that spend every waking
hour chasing returns, analyzing complicated charts, dissecting
corporate balance sheets or scouring the market on a daily basis
searching endlessly for a perfect buy.
Lesson Learned: There are roughly 15,000 mutual funds in the

country with approximately two professional fund managers each.
Of those 30,000-ish fund managers, guess how many have beat
the static, mindless S&P 500 index more than ten years in a row?
Answer…? …. Get this: Just one. The legendary Bill Miller from
Legg Mason. Undeniable statistics prove that the S&P typically
out-performs over 80% of managed mutual funds year after year,
leading the sharp ones to realize that when it comes to efficient
and successful investing, it rarely has to be complicated for it to be
effective.
64 INVESTING
4. Cut the losers, ride the winners

Dating: The first handful of dates were the stuff legends are made
of, but by the time mid terms rolled around, Crazy Mindy crashed
my college roommate’s car, emptied his bank account, shredded
his classic Dark Side of the Moon poster, caused him to miss the
Macro Economics final and managed to give him one very fat lip. By
the time graduation took place, my roommate ended up blowing
his entire senior year trying to turn Crazy Mindy into the person
she once appeared to be.
Investing: On paper, the company looked like a true winner. Not

only was the stock going through the roof but even Madonna used
its products. At first the investment took off, but no thanks to a
deadbeat CEO and a few federal regulations tossed in, the stock
began its perpetual downward spiral. Convinced it would come
back, you held on, only to wake up realizing you would have been
far better off giving Crazy Mindy your money to invest.
Lesson Learned: Crazy Mindy could care less about my roommate

and likewise, stocks could care less about you. They don’t know
who you are and only you can fall in love with them. Love or
money, when something isn’t working, get out. Just cut the losses,
move on and live to fight another day. The quicker you do that, the
better things typically turn out.
5. Don’t give up on the first date

Dating: Dinner at The Palm was better than if your Mets won
another Series. The guy made you laugh, he held the door and a
Grey Goose made him look like Brad Pitt. But back at your place,
just as the room sweltered to high noon out on the Serengeti, your
mother’s voice politely whispered to you, “Not on the first date.”
Wisely, you pushed back and let something called “time” nurture
the relationship.
Investing: The financial advisor seemed like a nice guy. He showed

you attractive rates of return, sported a Tom Cruise smile and even
served cappuccino in fancy bone china with lace doilies to match.
INVESTIN G 65
So you rolled the entire 401(k) into an IRA, only to later realize it
cost you a huge up-front commission on high fee investments that
caused you nothing but losses to boot.
Lesson learned: Treat your money like you’d treat your body: Don’t
give it up on the first date. Taking time to nurture a relationship
will not only make your mother proud, but it will certainly provide
you with one of the most important keys to financial and dating
success.
6. Diversification is the key to success

Dating: Adam looked like Alan; Alan acted like Arnold; Arnold
smelled like Arnie and Arnie reminded you of Alex. And just when
you thought you found the Perfect-A, Aden stood you up just like
Albert and Abe once did (or was that Alfonse?). It was then, in one
fleeting moment of revelation, you finally realized the problem had
nothing to you, but everything to do with guys whose names start
with the letter “A”.
Investing: Dot-coms. … Late 90s. … Need I say more?
Lesson Learned: Diversifying your investments is a critical key

to investment success. Load up in one sector or stock and it’s
not a question of if disaster will strike, it’s usually a question of
when. Spread the risk, diversify your investments into the prudent,
timeless fundamental asset classes and of far more importance,
stop dating guys whose names start with the letter A.
CONCLUSION
Bad date? Who cares? Next time something doesn’t turn out so well,
simply shake hands with your date and thank them for making you a
richer person.
After all, when it comes to love and money, hopefully here you’ve
learned it’s all very much the same.
66 INVESTING
7 Ways to Save $100 per Month

Saving for retirement is not always easy. There are bills to pay, clothes
to buy, movies to see and a long list of many other things that can
easily get in the way.
With this in mind, I wanted to point out a few ideas on how to save
$100 per month. If it doesn’t sound like saving this amount would
equate to much, over time it can really mean much more than you
most likely think.
Let’s suppose you invest $100 every month, and let’s also assume you
invest it into a stock index fund that earns an average return of 8% per
year. Before revealing the results, note the emphasis on “index fund”.
This is important to highlight because when investing in an index such
as the S&P 500, not only do you get instant diversification, but you’d
also keep the fees you pay and the taxes you owe to a bare minimum
as well.
INVESTIN G 67
Let’s also suppose the amount you save increases by 3% per year
to keep in line with a hopeful increase in wages. So, invest $100 per
month in an index fund such as the S&P 500 and at an 8% average rate
of return, the following would result:
IF YOU INVEST FOR… YOUR INVESTMENT WILL GROW TO…
10 years $21,796
20 years $65,265
25 years $101,454
Looks good to me. Here’s a few creative ways to help you get there:
1. Invest your refund

Are you one of the unlucky people to get a tax-refund this year?
Remember, your tax refund is merely an overpayment of estimated
taxes or withholdings that earned Uncle Sam interest, not you. If
you were one of the unlucky people to receive a refund, evaluate
your estimated taxes or withholdings and don’t give it to Uncle
Sam as a tax-free loan. Instead, invest it. Doing so could very well
get you that $100 monthly savings you’ve been looking for.
2. Brown bag it
Working? Let’s suppose you eat lunch out every day and the
average meal costs $12. That’s $240 per month in food costs. To
save money, would you eliminate dining out every day? Not unless
you wanted to miss out on the latest business news or how Jane’s
date went with Jeff. So, let’s assume you cut down on the dining
and ate out once a week. Doing so would bring the total monthly
food costs to right around $50. You still have to feed yourself, right?
So let’s assume you spent about $100 for some groceries. Do the
math, and there you have it – you’re left with a $100 dollar monthly
savings.
68 INVESTING
3. Rideshare to Work
Let’s suppose you travel 15 miles each way to work, your SUV
holds 20 gallons and gets 15 miles per gallon. Two more variables
needed: Let’s suppose gas costs $2.75 per gallon and there’s 22
working days in the month. How much would you save if you
carpooled with two friends? Sounds like one of those SAT brain
twisters, right? And you thought you were out of high school – Do
the math and that’ll save you roughly $80 per month and get you
a nice ride in that carpool lane as well. How great is that?
4. Energy Checkup
Are there ways you can save a few dollars on your monthly energy
costs? For me there was. A couple of small touch-ups around the
house and I am now helping keep Al Gore happy. With a few
mouse-clicks on the “Home Energy Checkup” at www.ase.org, I
quickly learned a few interesting ways to save a couple of dollars
every month on my energy bill and maybe you will too.
5. Skip the Root Beer

It’s a rare day when I don’t have a craving for an ice-cold Root Beer.
Suppose I didn’t listen to my own advice above and ate out five
times a week. If a Root Beer costs $1.50, I just spent $30 per month.
For savings and nutritional reasons, I should have been drinking
water. While the $30 savings won’t get me my $100, it’ll definitely
help get me there and make my Mother happy along the way as
well.
6. Clip Coupons
If you’re just like me, that means you eat a few boxes of Cinnamon
Toast Crunch every month along with a few dozen South Beach
Protein Bars and bags of Turkey Jerky. Interested in saving a few
dollars on these monthly purchases? Websites such as www.
coupons.com claim you can print a few of their coupons and save
over $100 every week. Who says Double Stuff Oreos are bad for
you? When I’m busy saving money when eating them, I would
completely disagree.
INVESTIN G 69
7. In-Home Beauty Regime

Thanks to a thinning hairline and my Flowbee, it’s been at least
a decade since I paid someone to cut my hair. Suppose each cut
costs an average of $50 and I need to cut my hair once every two
months. By doing it myself, I’ve basically saved $25 per month.
Care to come by for a Flowbee? Would you do it yourself? Doubtful
on the former, possible on the latter. There are also a few possible
things you can do to reduce your monthly beauty costs such as a
do-it-yourself manicure or mudpack.
Better nutrition? Energy efficiency? Getting yourself rich instead

of Uncle Sam? As far as I’m concerned, over a ten-year period of
time, I can think of 21,796 reasons to save $100 per month and
hopefully you can too.
70
THREE
INCOME CHAPTER 71
More Income, Less Risk

The genius behind a
peanut butter and jelly sandwich
Compared to previous generations, people are living longer in their
retirement years. But with that advancement comes increased concerns
– the rising cost of living, and even worse, running out of money.
Those worries are leading more investors to seek new and innovative
ways to get higher returns on their investments, although sometimes
they’re disregarding the safety of their principal. Yet there are income
strategies that can do both for you – provide a decent rate of return
without jeopardizing your principal.
You may find this to be a bit “nutty”, but to begin a brief discussion
about a unique income strategy, I will first mention what I truly be-
lieve to be one of mankind’s greatest creations: Yes, the one-and-only
peanut butter and jelly sandwich. Who was the person – as bold as
Einstein, as clever as Da Vinci – to invent the pb&j? For the moment,
I’ll put this important thought aside. One thing the legendary pb&j
72 INCOME
should forever remind us of, however, is that most often “the whole is
greater than the sum of its parts”.
Alone, peanut butter and jelly are merely two separate jars of everyday,
somewhat ordinary food products. Together in a sandwich, they
represent eternal soul mates, a true marriage made in heaven.
Similarly, there are two investment products you most likely have not
considered for yourself. Just like pb&j, together these investments
could possibly create the greatest income sandwich your income-
hungry belly has ever had.
Now before I tell you about this income sandwich, let’s take a brief
look at some of the places from which you might consider getting
more income while keeping your money safe.
Certificates of Deposit (CDs) certainly are safe. Between today’s

low interest rates and taxes on the earnings, yes, you’ll protect your
principal, but you’ll starve while doing so. If you put $100,000 in a five-
year CD, you’ll earn around 5%, or $5,000 a year. But if you’re in the
28% tax bracket, after taxes you’ll only net around $3,600. Furthermore,
the increased taxable income could push you into a higher bracket and
possibly affect your Social Security taxation.
What about bonds? Sure, you’ll likely get your money back at the
maturity date, but to get any reasonable rate of return, you’ll have
to hold a bond longer than it’ll take my New York Islanders to win
another Stanley Cup. The bond may also be “called”, and if you sell
it before the maturity date, you may get less than what you paid for
it. In an uncertain interest rate environment, purchasing long-term
bonds with low rates of return is not something I’m a big fan of.
Then, of course, there’s the stock market – for dividends, preferred

stocks, real estate investment trusts (REITs), Collateralized Mortgage
Obligations (CMOs), etc. Unless you have the stomach for potential
loss and uncertainty, to get more income you need to be creative.
Think “outside the box.” Be imaginative. And that’s where my income
sandwich comes in.
INCOME 73
The peanut butter side of this income sandwich is something called an

immediate annuity. Offered by insurance companies, many of which
have been around for well over 100 years, an immediate annuity is
essentially an investment vehicle that provides you with a “pension”
for the rest of your life.
Consider, for example, my friend Bill, who’s 77 years old. Laws of

probability say he can easily live another 10+ years, and Bill is hungry
for more income. After we explored all his options, Bill fell in love
with my income sandwich and decided it was what he wanted to
eat. So Bill put $100,000 into an immediate annuity, and in exchange
for this one-time deposit, he gets a lifetime income stream of $12,052
per year. All through Bill’s life most of the income is tax-free, thanks
to the Internal Revenue Service (IRS) gift known as the exclusion
ratio rule. The problem is, if Bill dies tomorrow, his original $100,000
investment is gone, which is a great deal for the insurance company,
but not so good for Bill’s wife, Francine.
To solve that problem, let’s switch to the other side of Bill’s income
sandwich. For the jelly, every year Bill takes $5,008 from the $12,052
annual income stream he receives from the immediate annuity and
deposits it into a life insurance policy. This policy provides Francine (or
their children) with a $100,000 tax-free death benefit, leaving Bill with
a net income of $7,044 per year. Where else could Bill get a 7% return
for income that’s mostly tax-free, never to change regardless of market
conditions, with a guarantee that the original investment returns to his
family tax-free upon his death?
I’ve worked with many “Bills”, especially during the time of

ultra-low interest rates. Some have invested thousands to create
their income sandwich, others have done it with millions. Needless
to say, you must have ample savings outside this income strategy for
various needs, especially for protection against inflation, healthcare
considerations, and other things. Keep in mind that age, health, and
other factors will ultimately determine your bottom line and whether
or not the strategy makes sense for you. In general, the older you are,
and the better health you’re in, the tastier this sandwich becomes. As
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long as you can qualify for life insurance (some people simply cannot),
the numbers could work out quite well for you and your beneficiaries.
Bonds? CDs? Stock market? Creamy? Crunchy? Super-chunky?

Everyone has their own taste, but one thing is for sure: In a low interest
rate environment filled with risk, uncertainty, and the fear many share
about outliving their savings, this income sandwich could be one well
worth sinking your teeth into.
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Build a Bond Ladder

Control cash flow and maturities
Bond mutual funds are the mainstay for many investors seeking income,
and with good reason. They provide professional management and
diversification among a number of different bonds, which could help
cushion a portfolio from a default. When interest rates rise, however,
the value of the bonds in the fund will likely fall, as will the fund’s value.
And unlike an individual bond, a bond fund doesn’t have a maturity
date at which you know you can retrieve your principal.
Yet there is a way you can allay interest rate risk – by building a bond
ladder using individual bonds. A bond ladder is simply a portfolio of
bonds with different maturities. For example, if you have $100,000 to
invest in bonds, you might have 10 bonds with a face value of $10,000
each, or 20 bonds with a face value of $5,000 each. The bonds would
have varying maturities, with one bond maturing in a year, another in
two years, another in three years, and so on. The resulting portfolio
would look like a ladder, as you will see shortly in our examples.
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The main benefit of this investment strategy is that by staggering the

maturity dates of the bonds, you won’t be locked into any particular
bond for any significant length of time. Let’s say that you invest your
$100,000 in a single bond with a 5% yield and a 10-year maturity.
During those 10 years until the bond matures, interest rates are likely to
rise and fall, and bond values will follow suit. (Remember, bond values
move inversely to interest rates.) But if interest rates are low at the
time your bond matures – and you’re ready to invest in another bond
– you’ll be stuck buying a bond with a low interest rate, or putting the
money into a money market account and waiting until the investment
environment improves.
If you have constructed a bond ladder, on the other hand, only one
of the many bonds in your portfolio will mature at any given time.
So although interest rates may be low when your one bond matures,
chances are the interest rate environment will be a little different when
the others mature.
Bond laddering is particularly beneficial in a rising interest rate

environment because it allows you to readily move your money out
of lower yielding bonds and into those with higher yields as interest
rates rise. You could argue that if you buy shares of a bond fund the
portfolio manager would do this for you, but some investors prefer to
have control over the process themselves.
A secondary benefit of bond laddering is that it lets you adjust the

income you receive from the bonds based on your personal cash flow
needs. With a bond, “What you see is what you get”. So suppose the
bond ladder you (or your advisor) are creating provides you with a
combined return of 7%, but you need 7.5%. To get that extra .5%, you
can usually swap one bond on the ladder for another. Typically, to get
that extra yield you would either increase the maturity length of a bond
or invest in a bond of a lesser credit quality. One or a combination of
these two elements will usually get you that extra yield. Needless to
say, adjusting maturity dates and credit quality can bring additional
risk into the ladder, hence the reason you never want to overload an
investment in one bond, but rather spread the risk out among many
bonds.
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Let’s take a look at a simple example. Suppose you need before-tax

income of around $6,000 per year and you have $100,000 to invest.
You can certainly invest the full $100,000 into a single bond paying
6%. But that “puts all your eggs in one basket”, and furthermore, it
won’t provide you with the flexibility you’d have from “laddering” the
$100,000 into several bonds, as shown below.
BOND AMOUNT YIELD INCOME
1 10,000 4.0% $400

2 10,000 4.5% $450
3 10,000 5.0% $500
4 10,000 5.5% $550
5 10,000 6.0% $600
6 10,000 6.0% $600
7 10,000 7.0% $700
8 10,000 7.0% $700
9 10,000 7.0% $700
10 10,000 8.0% $800
TOTAL INCOME $6,000
The bonds in a bond ladder are not necessarily “locked” into place.
While you own the bond, the yield won’t change but the value will.
Depending on what happens to interest rates during the bond ladder
period, the values of each bond can rise or fall. As bond values rise and
fall, there are many opportunities for tweaking the ladder. For instance,
yield and length of time until maturity can be updated when prudent
by selling the bond and replacing it with another one. However, selling
the bond prior to its maturity date would only make sense if you can:
a) buy another bond that will provide you with equal or better yield;
b) decrease the maturity date; and finally, c) purchase a bond of equal
or better credit quality.
The maturity date comes into play if the bond decreases in value and
you want to know how soon the bond’s principal will be returned to
you. The answer, of course, is at maturity, or when the bonds reach
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their full face value. But remember, if you cashed in the bond prior to
maturity, you will get whatever value the market places on the bond
at the time you sell it. It can be worth more or less, and again, it all
depends on the value the market places on that bond. Think of it this
way. Suppose you bought a bond for $10,000 paying 6%, and a little
while later you want to sell that bond. But now, people can buy new
bonds of the same credit quality and maturity dates that pay not 6%,
but 8%. Who would want to buy your bond paying 6%? The only way
someone would want to is if they can get a comparable interest rate
of 8%. So what do they do to make it comparable to 8%? They will give
you less money for that bond so the yield is the same as if they were
buying a new bond at 8%.
The same thing works in reverse. Suppose you want to sell that bond
paying 6%, but at that time the same type of bonds are paying 4%. The
only way it would make sense for you to sell that bond is if someone
paid you more than what you invested.
Another point worth mentioning: Cash flow planning. Each bond

usually pays the interest income at different times. For example, one
bond might pay you in January, two more might pay in March, another
in July, etc. Any advisor constructing a bond ladder will almost always
be constructing it with computer software that will provide an instant
cash flow report. The total amount of income being paid from my
simple example above might be 6%, but remember, it gets paid out
at different months during the year. For those who need exactly $500
per month ($6,000 per year paid out monthly), a cash reserve outside
the bond ladder would be required to keep income consistent. This
is usually perceived as a disadvantage of bond ladders versus bond
mutual funds, but I very strongly believe the extra “frustration” of a
bond ladder is very much worth the rewards in return. And as creating
a bond ladder is something that is typically done with an advisor,
planning cash flow with a “side pool” of cash reserves is actually a very
simple process.
Something else to keep in mind is that all my examples have not

included a discussion on taxes. Income from corporate bonds are fully
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taxable. Income from municipal bonds are tax-free on the federal

level and typically tax-free on the state level (as long as you reside in
the state where the bond is issued) as well. Government bonds are
typically taxed only at the federal level.
Many financial advisors overlook bond ladders because it’s easier

to drop a client’s money into a bond fund than it is to research and
purchase a number of individual bonds. So if you are interested in
individual bonds and building a ladder of your own, be sure to ask
your advisor about this strategy.
If you’re looking to preserve your investment principal, especially in

your retirement years, a bond ladder can be an excellent choice for
a portion of your overall investment portfolio. A well-diversified
ladder, built with bonds that have good credit quality, and not a lot of
money put into any one bond, can bring peace of mind to an income
investor.
I’ve met many income investors who put their money into bond mutual
funds instead of individual bonds. As interest rates rise, presumably
the value of their funds drop and they begin to worry. A bond ladder
can reduce that concern. With the ladder, you know the maturity dates
of your bonds, with bond mutual funds you do not. And quite frankly,
I’ve also seen many decent ladders that have provided better interest
income than bond funds. So for those seeking “more income and
less risk”, and are investing in bond mutual funds, this idea can be
a fantastic place to start when evaluating your portfolio to solve that
dilemma.
There are a couple of caveats that need to be pointed out, however. In

general, you shouldn’t attempt to build a bond ladder unless you have
enough money to fully diversify and create at least five rungs – each
in the $10,000 to $20,000 range, preferably. However, depending on
a variety of factors, especially if you are investing a small amount of
money, buying bonds at $5,000 can also be prudent. Secondly, a bond
ladder presents less risk only if there is no default on a bond, so be sure
you understand bond credit quality before buying any bonds.
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Personally, this bond ladder concept is one of my all-time favorites,

and I hope you’ll get as much use out of it as I have. The following
table illustrates how you could construct a 10-year bond ladder by
buying bonds that mature in two, four, six, eight, and 10 years. Then,
every time one of these original bonds matures, you purchase a new
10-year bond. Bear in mind that my example below assumes a rising
interest rate environment. Needless to say, it is entirely possible
that when you set up a bond ladder you can be reinvesting during a
declining interest rate environment, hence maintaining a bond ladder
involves reinvestment risk. This is one of the major risks in building a
bond ladder and should not be overlooked.
It is always best to construct bond ladders during rising interest rate

environments, but certainly no one can guarantee what will happen
to interest rates once a ladder is established. These are careful
considerations that need to be factored into one’s own personal
situation and something that certainly deserves further attention prior
to investing.
But one very important thing to remember: Whether you are investing
in bond mutual funds OR bond ladders, the same type of reinvestment
risk is inherent in both vehicles. The mutual fund manager or you/your
advisor bear the same risk. So, with this very important fact in mind,
why not go in the direction that at least gives you a significantly better
chance of preserving your principal – a bond ladder that has maturity
dates versus a mutual fund that simply does not?
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INITIAL PORTFOLIO FUTURE PORTFOLIO
Two-year bond 5.75%

2 yrs. out
i interest
6.00% 6.00%
Four-year bond 4 yrs. out
interest interest
6.25% 6.25% 6.25%

Six-year bond 6 yrs. out
interest interest interest
Eight-year bond 6.50% 6.50% 6.50% 6.50% 8 yrs. out

interest interest interest interest
Ten-year bond 6.75% 6.75% 6.75% 6.75% 6.75%

interest interest interest interest interest
REINVESTMENT 6.75% 6.75% 6.75% 6.75%
6.75% 6.75% 6.75%
6.75% 6.75%
6.75%
AVERAGE 6.25% 6.45% 6.60% 6.70% 6.75%

RETURN
AVERAGE
6 years 6 years 6 years 6 years 6 years
MATURITY
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As a side note, you will frequently hear investors refer to bonds as

being “short term”, “intermediate term”, and “long term”. Gener-
ally, just know that a short-term bond is one that matures in less
than five years, an intermediate bond in five to 12 years, and a long-term
bond in over 12 years.
Lastly, several times above I noted that it’s important to pay attention
to the credit quality of the bonds being used in your ladder. The two
agencies that are most frequently referred to in assigning ratings to
corporate bond issuers are Moody’s Investors Service (Moody’s)
and Standard & Poor’s Corporation (S&P). Both firms focus on a
company’s financial condition and the industry in which it operates at
that particular point in time. The agencies often revise their ratings of
companies, so it’s important to make sure you are looking at current
ratings and not the ratings from years ago.
Conceptually, corporate bonds are broken down into two categories:

investment grade and below investment grade (aka “Junk Bonds”).
Investment grade bonds bear less risk than Junk Bonds, so as a rule
of thumb, if you see a bond in your ladder paying an abnormally high
rate of interest, high chances are that it is a junk bond.
The chart below summarizes the different ratings each company

places on bonds. Keep in mind that a bond ladder can also incorporate
Certificates of Deposit and government-issued bonds. For purposes
of this section, however, I am focusing primarily on corporate bonds,
which typically comprise the majority of the bond ladders I construct,
and are the ones I have seen in many other portfolios.
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Investment Grade Moody’s S&P
High Grade: Aaa AAA
Moody’s Best quality, smallest degree of risk.

S&P Ability to meet financial obligation on
the bond is extremely strong.
High Grade: Aa1, Aa2, Aa3 AA+, AA, AA-

Moody’s High quality by all standards. Not as
strong as higest grade.
S&P Ability to meet financial obligation on
the bond is vey strong.
Upper Medium Grade: A1, A2, A3 A+, A, A-
Moody’s Contains many favorable investments

attributes, secure.
S&P The issuer’s capacity to meet its financial
obligations is strong
BBB+,
Medium Grade: Baa1, Baa2, Baa3 BBB, BBB-
Moody’s Speculative characteristics.
S&P The issuer’s capacity to meet its financial

obligations is strong.
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Below Investment Grade Moody’s S&P
Speculative Grades: Ba1, Ba2, Ba3 BB+, BB, BB-
Moody’s The future of these bonds cannot be B1, Ba2, Ba3 B+, B, B-
considered as stable.
S&P These bonds face exposure to adverse
business or economic conditions which
could lead to an issuer’s inadequate
capacity to meet its financial commitment.
CCC+, CCC,
Highly Speculative Grades: Caa1, Caa2, Caa3 CCC-
Moody’s These bonds are of poor standing. Such
issues may be in default, or in significant Ca CC
danger of not meeting obligations.
S&P These bonds are vulnerable to
nonpayment, and are dependent upon C C
favorable economic conditions for the
issuer to meet its financiaal commitment.
Default:
S&P These bonds are in payment default. D
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The Power of Dividends

Using stocks to generate income
Most investors have some familiarity with stocks. Each share of stock
you hold represents actual ownership in a company. Thus, as a large
or even a small stockholder, you stand to gain or lose money based on
how that company performs.
Stock investments in your portfolio can increase in value in one of two

ways: By moving up in price, or by generating income in the form of
dividends. The latter tends to be underrated, so I’d like to spend some
time discussing it.
First, let’s review our understanding of dividends. When a company

makes a profit, a portion of that money is often distributed to its
stockholders (individual stockholders or mutual fund shareholders) in
the form of cash. That distribution is called a dividend.
Dividends are typically paid by large companies that generate

regular profits but are too mature to grow significantly. Examples of
those companies are General Electric and Coca-Cola. Fast-growing
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companies in new industries such as telecommunications and

biotechnology seldom pay dividends. Instead, they reinvest their profits
in technology that will encourage the company’s further growth.
Prior to the bull market of the 1990s, the average dividend yield on
stocks in the Standard & Poor’s (S&P) 500 Index was about 4%,
according to the September 10, 2002 issue of Wealth Management
Insights. The S&P 500 is an unmanaged index of stocks that is generally
considered representative of the market as a whole. For every $100 you
invested in the S&P 500, you would have received $4 in dividends.
During the 1990s, however, dividends declined as many companies

reinvested their profits in an attempt to generate much-desired growth.
By the time the bull market ended in 2000, according to Smartmoney.
com (October 7, 2002), the average dividend yield on stocks in the S&P
500 had declined to 1.5%.
Then, in the wake of the dot-com bust, steady income came into favor
again and companies began increasing dividends. This time, however,
they had a special incentive: Tax cuts on dividend distributions, thanks
to the Jobs and Growth Tax Relief Reconciliation Act of 2003.
In the past, dividends were taxed more heavily, much to the chagrin
of many investors who argued that this amounted to double taxation
because a company was taxed on its profits and then shareholders were
taxed when those same profits were distributed as dividend payments.
The Jobs and Growth Tax Relief Reconciliation Act dramatically cut
the federal tax rate on stock dividends – from a maximum of 38.6%
to 15% – and many companies began increasing their dividends.
For example, in 2004, Microsoft made a special $32 billion one-time
dividend payment of $3 per share and doubled its regular dividend to
32 cents per share.
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This change in the tax law makes dividend-paying stocks and mutual
funds particularly attractive as an income-producing option for retirees.
And you need not worry that dividend paying stocks produce income
but provide low returns. If you take a look at the dividend-paying
stocks in the S&P 500, they had an average return of 28.08% in 2003,
the year of the Jobs and Growth Tax Relief Reconciliation Act.
The new tax rate is effective from 5/6/03 to 12/31/08 (retroactive to 1/1/03). After
2008, tax rates revert to the pre-2003 tax law.
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Preferred Stocks
Another way to create income
Many investors searching for additional income in their retirement
years automatically look toward bonds and other debt instruments.
But bonds aren’t the only way retirees can generate income. Stocks
provide viable options as well. “Stocks?” you might ask. Yes, some
stocks. Preferred stocks, for example. Even though preferred stocks are
listed as equity on a company’s balance sheet, they act more like bonds
than as common stocks.
Holding preferred stock, like common stock, means you have

ownership in a publicly held corporation. Yet preferred stockholders
are in a different class, which generally has priority over common
stockholders when it comes to earnings and assets in the event of
liquidation. For instance, if the company goes bankrupt, preferred
stock dividends are paid after the company’s debt but before dividends
on the company’s common stock.
That level of security isn’t the only reason to buy preferred stocks,
however. They’re also a great way to generate income. That’s because
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preferred stocks have a stated dividend which must be paid before

dividends are distributed to those who hold common stock. Dividends
typically range from 5% to 9% per year and are paid quarterly or
monthly. And, most preferred stocks are eligible for the 15% tax rate
on dividends (preferred stocks issued by real estate investment trusts,
or REITS, being the notable exception). So if you’re looking for less
volatility, and a higher cash return with more liquidity than bonds for
your retirement portfolio, preferred stocks are worth considering.
Where do you find preferred stock? In the same place you find common
stocks. Take a look at Yahoo! Finance or CNBC. On Yahoo! Finance,
preferred stocks are listed by the ticker symbol of the issuing company,
followed by an underscore, followed by the letter P, followed by the
series letter (if there is one, and there probably is, because companies
that issue preferred stocks often have more than one series and use
letters of the alphabet to distinguish them). On CNBC, preferred
stocks are listed by the company ticker symbol, followed by a vertical
PR, followed by a letter indicating the specific issue.
As with any investment, some preferred stocks are of a better quality

than others. One way to determine the quality is by looking at the
stock’s rating. Like corporate bonds, preferred stocks are rated by
Standard & Poor’s or Moody’s. Although the agencies use different
scales, the general rule of thumb is much like a school report card: You
want to get an A, and the more the better. Anything below a B grade
is garbage.
It’s a good idea, however, to know a little bit more about what you’re
buying before you dive in. So once you find a preferred stock you
think you like, take a look at the details and get down to business. It’s
important to understand what the company issuing the stock does,
just as you would before buying any stock. But you also need to do a
risk analysis like you would with bonds. In other words, how likely is
it that the company will be unable to pay its preferred dividends? One
way to figure that out it is to determine its coverage ratio. To calculate
this ratio, you simply divide the company’s EBITDA (earnings before
interest, taxes, depreciation, and amortization) by interest expense
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plus preferred dividends. The higher the coverage ratio, the better the
chance for success.
Of course, that may be more work than the average investor wants to
do, which is where a financial advisor comes in. He or she can help you
analyze a company’s risk of “default” and answer a number of other
key questions about investing in preferred stock. For example, are the
dividends cumulative? Are the shares redeemable, and if so, when?
What is the likelihood of redemption?
Another key detail to understand: The maturity date, which on preferred

stocks can often be quite lengthy. Similar to a bond, preferreds do
have a maturity date, and those dates are sometimes very, very long.
Stay away from the long maturities – the higher interest rates go, the
quicker the value on the preferred will drop. As much as possible, stay
with short-term preferreds with higher credit quality.
So before you rush to take advantage of investing in a “preferred”

class of stock, be sure you know the answers to these and other issues.
If you’re unable to find the answers on your own, ask someone who’s
qualified to help you.
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Real Estate Without the Headache

Using REITs for income
Many investors want to participate in the real estate market – with

good reason. Real estate can help diversify a portfolio of stocks, bonds,
and cash. And although past performance is no guarantee of future
results, recently the real estate market has being performing well.
How well? Since 2001, low mortgage rates have fueled a boom in the
real estate market. Construction of new homes and apartments have
appeared to defy all forecasts of a slowdown, shooting up 14.5% in a
single month – from December 2005 to January 2006 – to a seasonally
adjusted annual rate of 2.276 million units. That was the fastest pace of
new builds recorded in the three plus decades since March 1973.
But the real estate market isn’t always easy to invest in. Buying
investment properties can require significant capital. Plus, analyzing
the residential housing market can be tricky. For example, many
experts consider the recent increase in housing starts to be a one-time
occurrence caused by unusually warm weather in January 2006, which
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likely prompted builders to start work on more homes. Other data

suggest that the housing boom is moderating: Average U.S. home
prices increased 12.02% from the third quarter of 2004 through the
third quarter of 2005. That represents a 2% decline from the previous
year’s approximately 14% increase.
The difficulty of investing in the real estate market in part led

Congress to enact a law in 1960 providing for the creation of real
estate investment trusts, or REITs. REITs are companies dedicated to
owning and sometimes operating income-producing real estate such
as apartments, shopping centers, offices, and warehouses. Essentially,
REITs allow investors to participate in the benefits of owning larger
scale real estate – often commercial properties – which tend to be less
volatile than the residential real estate market.
Basically, there are two types of REITs: Public and private. The major
difference is that public REITs are just that, publicly owned and traded
on the major exchanges. But let’s look at what that means in more
detail.
Regulation
Public REITs must comply with the requirements of the Sarbanes
Oxley Act, including quarterly financial reporting. This leads to a certain
degree of financial transparency that some investors feel adds security
to the investment. Private REITs, on the other hand, are required to
do little in the way of disclosure, other than file an initial offering
registration with the Securities and Exchange Commission.
Volatility
Because they aren’t exchange-traded, private REITs aren’t subject to
the daily fluctuations of the market as public REITS are.
Liquidity
Investors can readily buy and sell public REITs, which isn’t the case
with private REITs. Private REITs charge anywhere from 10% to 16% in
up-front fees. Redemptions are generally permitted two or three years
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after the date of the initial investment, if at all, and are usually offered
at the par price (the price at which the security was issued) or less.
Private REITs may even restrict investor redemptions. For example, in
August 2004, Wells Real Estate Funds announced that it would only
honor redemption requests resulting from the shareholder’s death.
Dividends
Private REITS have historically yielded dividends of 7% to 8%,
compared with only 5% to 6% for public REITs.
You can invest directly in REITs or buy shares of a fund that invests
in REITS. It’s a good idea, however, to engage a financial advisor to
help with the purchase decision. Factors that must be evaluated when
investing in REITs include: the geography and type of properties the
REIT holds, the economics of those properties, the experience and
expertise of the management team, the financial terms of the REIT
investment, and your individual financial circumstances and goals.
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Government-Backed Mortgage Securities

Introducing Ginny Mae
You’re probably familiar with Ginny Maes (GNMAs). You may even
think of them as so-called “safe” securities. But think again, because
they may not perform as well as you might expect in certain economic
environments.
How do you know if GNMAs are a good investment? First,

let’s go over what they are. Certain U.S. government agencies
are authorized to sell debt instruments, or bonds. GNMAs are
debt instruments issued by the Government National Mortgage
Association (GNMA), which is part of the U.S. Department of Housing
and Urban Development (HUD). Essentially, the Government National
Mortgage Association packages or pools together mortgages. Bonds
based on these mortgages are issued in denominations of $25,000.
GNMA investors are paid monthly distributions that represent both
interest payments and principal repayments on those mortgages.
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Most investors have a hard time scraping together $25,000, so those

interested in GNMAs usually purchase shares of a mutual fund that
invests in them. Because GNMAs are backed by the full faith and credit
of the U.S. government, many investors think GNMA funds are“safe”.
But this guarantee is limited; it covers timely payments of principal
and interest on the loans underlying the securities while the price of
the securities will still rise and fall. As a result, the value of a mutual
fund that holds them will fall too.
The major price fluctuations of GNMAs are related to prepayment

risk, which is the risk that homeowners will pay off their mortgages
early. And you can get an idea of how many homeowners are likely to
do that by looking at the economy.
GNMAs are also affected by changes in interest rates. When interest

rates decline, people with mortgages usually refinance at the lower
rates. As they do so, more money is returned to the GNMA pool, and
GNMA fund managers in turn, are forced to reinvest that money at
prevailing lower interest rates. Therefore, GNMAs tend to perform
poorly when interest rates are declining.
Yet, like all fixed income funds, GNMA funds may also decline in value
when interest rates go up. This is because GNMA funds hold a portfolio
of mortgages purchased at lower interest rates, and people who took
out those mortgages have no incentive to refinance or “prepay” them
when interest rates are higher.
If GNMAs usually provide investors with poor returns when interest

rates are either rising or falling, you may be asking, just when do
GNMAs tend to perform well? The answer: When interest rates are
stable, or rising only modestly. It’s at those times that GNMAs are
inclined to earn more than comparable bond funds.
Today, at the time of this writing, interest rates are rising, which is
bad for GNMAs. But the Federal Reserve has thus far raised interest
rates gradually and moderately, which is good for GNMAs. The Lipper
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GNMA Funds Average return was 2.35 % for the year ending February
29, 2005. During the same time period, the Lipper U.S. Treasury Money
Market Funds Average returned 0.83 percent. For the time being,
GNMAs are doing all right. And if the U.S. economy continues to grow
modestly, but not enough to encourage the Federal Reserve to increase
the pace of interest rate increases, GNMAs may continue to perform
well. But remember, no investment is a sure thing.
FOUR
BONDS CHAPTER 97
Understanding the Effect

of Interest Rates
Duration: What is it?
Many of us first became aware of bonds – in the form of savings bonds
– when we were children. Years ago, they were thought of as a good
way to save money. Chances are, you received a bond or two very
early in your life. It may have been your grandparents, or your aunt
and uncle who gave you a bond for some special occasion. Years later,
when you cashed them in to buy your first car, a guitar, or some other
“necessity”, it was kind of neat to see that bonds bought at roughly
half their face value could later be redeemed for much more.
Bonds are still considered, by many people, to be a very safe investment

and a component that can add stability to their retirement vehicle. To
some extent that’s true. But it’s not quite that simple.
Bonds have typically been used to compensate for the low return on
other interest-rate-sensitive investments, like Certificates of Deposit
98 BONDS
when interest rates drop. However, if you buy certain types of bonds
with very long maturities when interest rates are low (i.e., corporate or
municipal), you would be locking in a very low rate of return. As soon
as interest rates start moving up again, the value of those bonds will
plummet, making them a poor long-term investment. The key is the
length of time you’ll be holding the bonds, which takes into account
their maturity and duration.
With that said, you probably should still invest in bonds. Before I
explain why, let’s review how interest rates affect them.
Generally, higher interest rates drive bond prices down. If you buy a
newly issued $10,000 bond when interest rates are at 8%, your bond
yields 8%, or $800 annually. But if after your purchase the prevailing
interest rate increases to 9%, a newly purchased $10,000 bond would
yield $900 annually. If you wanted to sell your bond, who would pay
you $10,000 to get $800 in interest when the going rate is $900? You’d
most likely have to reduce your price, making your bond less valuable
than a newly issued bond.
But you shouldn’t sell all of your bonds whenever interest rates rise.
Bonds are an important part of most portfolios. Instead, I recommend
that you manage your bonds’ sensitivity to interest rate changes by
paying attention to their maturities.
When interest rates are rising and bond values are falling, you don’t
want to be “locked in” to a bond that doesn’t mature for years because
it will be worth less than a newly purchased bond. But if you purchase
faster-maturing bonds, you’ll be able to replace lower-value bonds as
they mature. You can do this yourself by purchasing individual bonds.
Or, you can purchase shares of a mutual fund that invests in bonds,
which should do this automatically.
Ideally, stick with individual bond purchases. A bond fund lacks one
major, important thing: A maturity date. If interest rates rise, the value
of the fund (in general) will drop, and you have no idea when your
principal will equal the amount you invested. When you invest in an
BONDS 99
individual bond, as long as the issuing company does not default, and
the value of the bond drops, then just hold on until maturity, the date
you will get your principal back.
Yet many people continue to invest in bond funds, and for that reason
our discussion of bond funds deserves a little further attention.
When you buy shares of a bond fund, you’ll want to look at two figures
provided by the portfolio managers: Average maturity and average
duration. Average maturity is the average time period until the bonds
in a fund’s portfolio mature. It’s usually quoted in years. Why look
at this number? Generally speaking, bond funds with lower average
maturities experience less price fluctuation than bond funds with
higher average maturities (assuming that both funds have comparable
credit quality). As a result, bond funds with lower average maturities
have less interest rate risk.
Average duration is an even better reflection of a bond fund’s sensitivity

to interest rate changes. That’s because it indicates the percentage
change in the price of a bond fund for each 100-basis-point (1%)
change in interest rates. For example, let’s say the bonds in Fund A
have an average duration of three years. That means, for each change
of 100-basis-points in interest rates (which is 1%), the bond fund’s
price should move 3% (1% x three years) in the opposite direction
of the interest rate change. So when interest rates rise 1%, the bond
fund’s price should fall 3%.
Another example: Let’s say the bonds in Fund B have an average

duration of 10 years. For each change of 100-basis-points in interest
rates, the bond fund’s price should move 10% – again, in the opposite
direction of the interest rate change. When interest rates rise 1%, the
bond fund’s price should fall 10%.
As the examples illustrate, the lower the average duration of the bonds
held in a fund, the less the bond fund’s price should fall when interest
rates rise. These calculations can get complicated, but most portfolio
managers do the work for you by classifying their bond funds according
100 BONDS
to average duration. Short-term funds, for instance, generally hold

bonds that mature within one to four years. Intermediate-term funds
generally hold bonds maturing in five to 10 years. And long-term funds
generally hold bonds that mature in five to 10 years or more.
The lesson: If you want to stay in bonds and offset interest rate risk,
look at a bond fund that’s classified as short-term.
BONDS 101
The Attraction of Bond Funds

Demystifying yield
With interest rates still at relatively low levels (at the time of this writing),
many investors have been looking for bond funds that generate an
attractive level of income. But which figure do you use to compare
funds: Dividend rate (also called distribution yield or distribution rate)
or Securities and Exchange Commission (SEC) yield?
First, let me explain dividend rate, which is what a bond fund pays you
in income distributions. This figure is typically calculated by:
1. Taking a bond fund’s income dividends in the most recent
month,
2. Multiplying by 12, and
3. Dividing by the fund’s share price.
Because this calculation assumes that distributions are constant for a

year, and that may not always be the case, the SEC developed another
figure called SEC yield and now requires mutual fund companies to
quote SEC yield whenever they quote dividend rate.
102 BONDS
Often, these two numbers are similar. At other times, one of these
numbers can be significantly higher. When interest rates are low, for
example, SEC yield is often much lower, and thus much less interesting
than dividend rate. So the question remains, which figure should you
look at? The straight answer: I can’t tell you. No one can. Some people
prefer dividend rate, some prefer SEC yield. I’d advise you to understand
how these figures are derived and make your own decision.
To get a better idea of how yield works, let’s consider a single bond
issued by a fictional company I’ll call Net Worth, a la The Apprentice.
The going rate is 6%; the bond pays $6 of interest per year for each
$100 of face value. Over time, as interest rates rise or fall, the resale
price of the Net Worth bond will fluctuate. For instance, when interest
rates decline, buyers might pay $103 or $107 for the bond’s higher
coupon, or interest rate. The company’s existing bonds will be more
attractive because the rate they are paying is higher than the rate on
bonds that are being newly issued. You can measure the current yield of
the Net Worth bond by multiplying the fixed interest payment of 6%
by the now-higher bond price (say $107). In this case, the yield would
be 6.42%. A bond fund’s dividend rate is figured similarly.
SEC yield, on the other hand, looks at things another way. It assumes
that a bond now trading at $107 is going to be redeemed at maturity for
$100, so the price will sooner or later drift down to that level and that
loss should be reflected in the yield figure. As a result, in a low interest
rate environment, when bonds tend to trade at higher than face value,
a bond fund’s SEC yield is often much lower than its dividend rate.
Again, I can’t tell you which figure to use. Some people prefer dividend
rate because SEC yield includes some worst-case assumptions. Take
load funds, for example. They calculate SEC yield as a percentage of the
share price that incorporates the highest possible sales charge, which
not all investors pay. Other people prefer to focus on the SEC yield
figure because it takes into account the eventual decline of a bond now
trading at higher than face value.
BONDS 103
My advice is that when you look at a bond fund’s yield figures, you
read the fine print to ensure that you understand what kind of yield
is being quoted, so you can accurately compare it to another fund’s
yield. Also remember that yield isn’t the only factor to consider when it
comes to bond funds. You should look primarily at total return, which
reflects a bond fund’s overall performance and includes both income
and changes in share price.
The tax and legal information in this chapter is merely a summary of

my understanding and interpretation of some of the current laws and
regulations and is not exhaustive. Investors should consult their legal
or tax counsel for advice and information concerning their particular
circumstances.
104
FIVE
ANNUITIES CHAPTER 105
Index Annuities
Is there such a thing as no-risk gambling?
What if it were possible for you to place a bet in such a way that you
were guaranteed to win? Not only that, you couldn’t lose any of your
money either. Think about it: If you guess right, you profit, and if you
guess wrong, you won’t lose any of the money you’re betting with.
Would you do it?
Most of us would love to get in on such a game. But does it really exist?
Stock market participation offers the potential for profit but also the
risk of loss. And while there’s no such thing as a perfect investment
– there are always some drawbacks – there is at least one type of
annuity that comes close to providing you with this upside potential,
except for the unavoidable fees and taxes, of course. It’s called an index
annuity and you may want to weigh the benefits of including it as one
component in your retirement vehicle.
106 ANNUITIES
I’ve received many inquiries asking for my opinion about index

annuities, but before discussing the specifics of these investments, it’s
important to understand the distinction between the types of annuities
because people confuse them far too often. To keep it simple, there
are essentially three categories of annuities: Immediate, variable, and
fixed.
An immediate annuity, sometimes referred to as an “income annuity”,

is an account with an insurance company where you invest a sum of
money in exchange for an income stream. Once the income starts it
cannot be stopped, and you no longer have access to your principal.
While these features may sound negative, an immediate annuity could
be a good investment for a small portion of your portfolio if it is used
to generate a safe and steady income stream that you cannot outlive.
Furthermore, income from an immediate annuity can be largely tax-
free due to something the Internal Revenue Service (IRS) calls the
“annuity exclusion ratio rule”. Be sure to consult with your financial
advisor and/or Certified Public Accountant (CPA) for more details on
the exclusion ratio based on your specific situation.
A variable annuity is an investment with an insurance company

where your money is allocated into “subaccounts”, which typically
try to mirror the performance of certain mutual funds. Gains in the
subaccounts are tax-deferred until withdrawn, and there are far too
many options found within variable annuities these days to outline
them in this column. It’s important to mention that these features,
such as return of principal, guaranteed growth, income, etc., come at a
price and should be investigated closely.
Before investing in a variable annuity, be sure to weigh the fees you

pay against the benefits provided. In many cases, you need to be
careful about investing in a variable annuity due to the high fees often
associated with them. Consider what one woman discovered when
she recently visited my office: Upon calling her annuity company to
check on her annuity’s fees, we found out she was paying just under
5% per year for “benefits” that turned out to be completely different
from what she was told when initially agreeing to the investment.
ANNUITIES 107
That said, there are indeed times when a variable annuity can really
benefit the investor. As I always say, what’s great for one person
might be awful for another. Everyone’s situation differs. So please, for
better or worse, always keep that in mind. Especially when it comes
to variable annuities, I despise advisors or the media that simply
make generalizations about certain investments, and especially about
variable annuities.
A fixed annuity is also a tax-deferred investment with an insurance

company, but your money is invested directly with the company itself
and not in mutual funds. Returns are based on a fixed rate of return
that will not change for the term in which you choose to invest. There
are also fixed annuities that offer a rate of return that can fluctuate
every year, however they usually have a minimum rate guarantee. So
here you have some upside potential and protection of your principal.

But another way that the rate of return is determined when you invest
in a fixed annuity is by the annuity company “linking” your earnings
potential to stock market indices, which is where index annuities come
into play. Basically, an index annuity is a fixed annuity that bases its
returns on market indices such as the Standard and Poor’s (S&P) 500,
NASDAQ 100, Dow Jones Industrial Average (Dow), etc. If the index
your money is linked to goes up, you make money. If the index goes
down, you won’t lose your principal or prior year’s earnings because
gains on your investment are typically “locked in” automatically on
your contract’s anniversary date, which is a nice feature of most
accounts.
For these guarantees, however, you will give up a few things, such as
having full access to your money and receiving the entire return the
index, such as the S&P 500, provides. (There are usually limits on the
return you will receive.) Also, keep in mind that annuity companies
use different methods of calculating your return, and as an investor,
you need to understand how the various crediting methods work
before handing over even a portion of your money.
108 ANNUITIES
In a true S&P 500 stock market index fund, you can obviously withdraw
all of their money at any time and receive the entire value of your
account at the time of withdrawal. In an index annuity, however, most
companies will allow you to withdraw only up to 10% of your account
every year. One particular company I researched offers the opportunity
to withdraw up to 86% of your money penalty-free at any time. If you
withdraw funds above these penalty-free amounts, you will likely face
surrender charges that could be steep. Yet at the end of the term, many
annuity companies will allow you to“walk away”with your full account
value with no penalty.
The lengths of annuity contracts vary from one year to many years,
so be sure you know how long you must commit to the investment
before going in. I’ve found that some people falsely believe investing
in any annuity means you never have access to your principal again,
an assumption which is simply not accurate. As described above, that
typically happens only when investing in an immediate annuity. You
can get your principal out of other annuities, but not without paying a
penalty or other fees.
In addition to limiting the access you have to your money, many

companies offering index annuities also limit the return you receive if
the indices rise. So now you may be thinking, if index annuities limit
my access to my money and to growth, why would I want to invest in
them? While those limits may not sound appealing, for the portion of
your money that you’ve earmarked for growth and that you absolutely
don’t want to lose, I certainly would not discount the peace of mind
an index annuity can offer. Many people want to keep their money
totally safe yet would like to have the opportunity to participate in the
stock market. For that mindset, an index annuity is certainly worthy of
consideration for a portion of your retirement portfolio.
One annuity company I’ve looked into limits your growth to 12% per
year. At the end of your contract year however, that 12% is locked
in and you can’t lose it. While that limit might seem like a recipe for
disappointment, personally, I’d be happy with a 12% return on my
ANNUITIE S 109
market investments that gets locked in at the end of every year. I

believe, and I’m sure many people would agree, that the toughest part
of stock market investing is knowing how to keep what you’ve earned
without giving it back, which makes the index annuity’s annual “lock
in” feature an attractive part of the investment.
On a final note, I often get asked if an annuity is a good investment

for an individual retirement account (IRA), given the fact that an
IRA already has tax deferment. While adding an annuity to your IRA
portfolio is certainly overkill in the tax deferment department, it does
not take into account the value of investing your money in a safe place
that offers stock market participation. And there is something to be
said for that feeling of security.
So, is there such a thing as no-risk gambling when it comes to

investing? Is an index annuity a good investment? My simple answer
is that it depends. As with any investment, there are advantages and
disadvantages that only you can determine based on your personal
needs, goals, tolerance for risk, etc. But if you want to keep your money
safe and have the opportunity for stock market participation, I would
recommend considering an index annuity for a portion of your money.
After all, I just invested a portion of my risk-averse wife’s IRA into one.
Upon further inspection of an index annuity, you may wind up doing
the same.
110 ANNUITIES
Variable Annuities
Should you purchase one?
A financial advisor tied up almost every last dollar a client owned in a
variable annuity because of the presumably high commission involved.
The client, on the other hand, didn’t realize that only a small portion
of the investment can be accessed every year. So when an emergency
situation arose and the client needed to tap into the annuity, the client
was out of luck. “Sorry”, said the financial advisor, “I thought you
knew.”
Horror stories abound about variable annuities being used to take

advantage of senior citizens. Of course, there are unscrupulous people
in every profession, and the financial industry is no exception. Without
knowing what you’re getting into, you too may agree to purchase
investment products that are inappropriate for you. For that very
reason, it’s important to ask plenty of questions and make sure you
understand exactly what you’re buying before you invest your money
with anyone. As for variable annuities, although it’s true that they aren’t
ANNUITIES 111
good investments for many people, there are some situations in which
they make a great deal of sense. Here are the two such instances.
1. You’re saving for retirement and have maxed out contributions to

other retirement savings vehicles, such as individual retirement
accounts (IRAs) and 401(k) plans.
If this is the case, and you’re currently saving for retirement in a
taxable account, a variable annuity might make sense – if you won’t
need the money for a number of years. Why? Because you’ll only
pay 15% on any long-term capital gains realized in your taxable
account, while withdrawals from annuities are taxed at rates as
high as 35%. As a result, you’ll probably need 10 to 20 years for an
annuity’s tax-deferral benefit to exceed the benefit of a lower tax
rate on long-term capital gains in a taxable account. Of course, this
depends on your tax bracket in 10 to 20 years as well: The lower it
will be, the better the case for a variable annuity.
2. You’re already retired, and you’re afraid you might outlive your
savings.
In this case, a variable annuity can really help you.Variable annuities
sometimes offer an optional feature called a guaranteed minimum
income benefit. This feature guarantees a particular minimum level
of annuity payments, even if you don’t have enough money in your
account (perhaps because of investment losses) to support that
level of payments.
There are also other cases that may warrant the purchase of
a variable annuity. An annuity may be a wise investment, for
example, if you could potentially be the target of a lawsuit
because assets in annuities are safe from lawsuits in many states.
Or, a variable annuity might make sense if you’re actively trading
in a taxable account (and paying short-term capital gains as high
as 35%) because you could put your money in a variable annuity
and switch between investments at no cost or for a small fee.
If you find yourself in one of these situations, a variable annuity may

be right for you. But not all variable annuities are created equal, so
112 ANNUITIES
it’s important to know how variable annuities work before diving

in. According to the Securities and Exchange Commission (SEC),
this means asking a number of questions.
• How will you use the variable annuity, and do you have
any other way to achieve the same result?
• Are you investing in the variable annuity through a
retirement plan or IRA?
• Are you willing to risk your account value decreasing
if the underlying investments perform badly?
• Do you understand the features of the variable annuity?
• Do you understand all of the fees and expenses that the
variable annuity charges?
• How long do you intend to remain in the
variable annuity?
• Does the variable annuity offer a bonus credit?
• Do you know the effect of the variable annuity on your
tax situation?
• Are you considering exchanging your current variable
annuity with another annuity that has different benefits,
features, or investment choices?
If you can’t answer all of these questions, you should work with a
reputable financial advisor who is thoroughly knowledgeable about
annuities. In the meantime, to get you started, the SEC offers a guide
to the workings of variable annuities. You can find it at www.sec.gov/
investor/pubs/varannty.htm#askq.
ANNUITIES 113
When You Need the Cash Now

Getting out of your annuity
Not all investments work out as you’d like them to, whether they’re
certificates of deposit, bonds, stocks, or even real estate. With annuities,
however, liquidating can be particularly difficult because you often must
pay a surrender fee. But even with annuities, you do have options.
First, let me make the point that annuities, like all investments, come
with both negative and positive aspects. Recently, the media seems
to be focusing on the negatives. I agree that many people who hold
annuities shouldn’t. But that’s not true for everyone. What may be
inappropriate for one person may be correct for another. And what’s
good for a person at a particular time may just not be suitable for that
same person at another time. Annuities have their purpose, and they
have helped many people in a variety of situations.
That said, what if you’re one of those individuals for whom an annuity
was a poor investment choice? And it doesn’t have to be because you
were tricked into buying one. You may have any number of reasons
for wanting to sell your annuity. For instance, maybe your financial
114 ANNUITIES
circumstances have changed. Perhaps you want to purchase a new

home, or are facing higher than expected medical bills, and you need a
lump some of cash right now. You want to get out of your annuity, but
you don’t want to pay a surrender fee.
The traditional choice for people who want to cash out of an annuity
is the 1035 transfer. Section 1035 of the Internal Revenue Code is a
statute relating to the transfer of money between financial products. It
allows you to move the money you’ve built up inside one annuity to a
new annuity, without paying taxes on the transferred funds. Moreover,
the new annuity will often pay the transfer fee, so you can get out of
your old annuity and into a new one at no cost.
The problem: You’re still in an annuity, just a different one. And while
this may make sense for some people, for others – particularly those
who want to exchange an annuity for a lump sum of cash – it doesn’t.
So how do you get out of your annuity altogether, without getting into
a new one? One option may be to sell your annuity in the secondary
market. Yes, annuities can be sold, much like stocks and bonds can.
Essentially, you sell your annuity to someone else, through a broker, of
course. You can sell it all at one time, or in parts.
Let’s say you want to make a down payment on a home and need a
lump sum of cash – $100,000 – but all you have is a monthly annuity
payment of $5,594.You could sell $2,014 of that payment for 60 months
(which would give you $120,840) for a lump sum of $100,000 –a little
less than the full value as an incentive for the buyer. In other words,
you’d receive $100,000 to make the down payment on your home, and
over the next 60 months, you’d still receive $3,580 per month from your
annuity. Sure it’s a trade-off, but it does provide you with a solution.
Selling an annuity can become much more complicated than that. For
instance, you could sell different parts of your annuity over different
periods of time, thereby raising even more cash. But the principal
remains the same: You get out of the annuity without the need to
transfer it. This process works for annuities that are currently in the
ANNUITIES 115
deferred stage, and even better for annuities that have been turned
into lifetime income (i.e., annuitized). The tax implications are the
same as if the annuity was surrendered to the insurance company,
meaning you won’t be taxed on the lump sum payment – only on the
“cost basis” of the annuity, which is something you definitely need
to discuss in detail with your financial/tax advisor before actually
surrendering the annuity.
So you can buy that house, pay those medical bills, or just get out of an
annuity whose purchase you regret. Just be sure you make that move
with an experienced financial advisor. Not all financial professionals
are skilled in this area. And as with any investment decision, it’s critical
that you are dealing with someone who thoroughly understands
the ramifications – tax and otherwise – of any transaction before it’s
executed.
116
SIX
IRA’S CHAPTER 117
Frequently Asked Questions

Contributions, withdrawals, and penalties
What’s involved in setting up an individual retirement account (IRA)?

Surprisingly, more than you might think. It’s not quite as simple as
deciding that you’d like to make a contribution for a particular tax year
and then funding an IRA. There’s beneficiary selection, which presents
other issues you’ll need to consider besides who should get your IRA
when you die.
Before funding an IRA, you should think about your financial needs
and how you will use your IRA during your retirement. Do you expect
that you will have to rely on your IRA for income? Or are you more
interested in creating a tax-deferred investment that you can pass on
to your heirs? In this chapter, we’ll explore some of the issues you
should carefully consider before you fund an IRA.
As a financial advisor, I get a lot of complicated questions about

traditional IRAs, particularly during tax season. For this column, I’ve
chosen to answer five of the most common that I’ve received.
118 IRA’S
Q. I will turn 70½ in 2005. Can I still contribute to my IRA?

A. Because you will not yet have reached age 70½ in 2004, you will
be eligible to make an IRA contribution for the 2004 tax year
(assuming you have had earned income). Since you are over age
50, you qualify for the 2004 “catch up” contribution limit of $3,500.
The maximum contribution allowed each year changes, as the
accompanying chart shows.
IRA CONTRIBUTION
Year Maximum Annual Age 50 or Over
Contribution Amount Maximum Amount

2002 $3,000 $3,500
2003 $3,000 $3,500
2004 $3,000 $3,500
2005 $4,000 $4,500
2006 $4,000 $5,000
2007 $4,000 $5,000
2008 $5,000 $6,000
Q. Are there any penalties for taking early withdrawals from my IRA?
A. Anyone may begin taking distributions from a traditional and/or
a Roth IRA, without penalty, after age 59½. With some exceptions,
such as first-home purchases and disability, withdrawals made
prior to age 59½ will be subject to a 10% penalty.
Q. If I begin taking distributions from my IRAs before age 70, will I still
have to take the same required minimum distribution (RMD) the
year I turn 70½? Or can I take credit for what has been withdrawn
earlier?
A. RMDs must begin by April 1 of the year following the year in
which you turn 70½. The amount that must be distributed each
year is determined by a formula provided by the Internal Revenue
Service (IRS). The key factors in the formula are the IRA account
IRA’S 119
balance on December 31 of the preceding calendar year and the

remaining life expectancy of the taxpayer (as determined by the IRS
in the RMD uniform lifetime table). If you took money out in years
prior to reaching age 70½, your current balance (which is used to
calculate your RMDs) will be smaller, but no credit is given toward
your future RMDs. In other words, you cannot use an earlier year’s
distribution as a credit against a future year’s distributions.
Q. I have several IRAs, a 401(k) plan, a 403(b) plan. Do I have to include

the 401(k) and 403(b) balances with my IRAs when determining my
RMD?
A. At age 70½, you would be required to take three RMDs: one from
your 401(k) pool, one from your 403(b) pool, and one from your
IRA pool. Since you have multiple IRAs, once you determine your
total IRA RMD, you can either withdraw that amount from each
IRA on a pro-rata basis or from one IRA.
A couple of important points need further explanation. First, if

you contributed to a 403(b), the money that accumulated in that
account before January 1, 1987 does not have to be distributed
until you are age 75. So at age 70½, the amount accumulated prior
to January 1, 1987 can be excluded from your RMD calculation.
Second, employees who are not 5% owners of a business and
continue to work past 70½ for an employer offering the 401(k)
or other qualified plan they participate in may delay the required
beginning distribution date for their 401(k) pool of money to April
1 of the calendar year in which they actually retire.
Q. Is it illegal for a custodian to charge a fee for processing IRA

RMDs?
A. No. However, the fees must be fully disclosed to the customer
before they are applied. You can most likely find this information
in the plan document for your IRA or in a fund prospectus. These
disclosure documents must be sent to new customers if a fee exists,
or to existing customers if a fee is being implemented or changed.
120 IRA’S
Converting to a Roth IRA

Factors to consider
Given the recent popularity of the Roth individual retirement account
(IRA), many individuals over age 70½ ask whether they should convert
their traditional IRAs to Roth IRAs. Essentially, this involves paying
income taxes on the traditional IRA assets in the year of the conversion
and creating a Roth IRA. Clearly there are consequences to taking this
action, and there are many factors to consider before making the move.
Let’s review some of them.
FACTOR 1: Can you convert your traditional IRA to a Roth IRA?

You may not be eligible to convert a traditional IRA to a Roth IRA. You
cannot convert if: 1) your income tax filing status is “married, filing
separately”; 2) your modified adjusted gross income exceeds $100,000,
regardless of your filing status as a single or joint taxpayer (starting in
2010, this law no longer applies but be sure to speak to your advisor
for more details); or 3) you inherited the traditional IRA. In addition,
IRA’S 121
the amount of your required minimum distribution (RMD) for the year
of the conversion cannot be converted. So, if you are age 70½ or older,
the first dollars coming out of your traditional IRA must be treated as
your RMD for that year, in which case they will be subject to income
tax. Only then can the remaining portion of your traditional IRA be
converted to a Roth IRA.
FACTOR 2: How will you use your IRA?

This is the most important factor to consider in converting your
traditional IRA to a Roth IRA. If you intend to use the funds for your
retirement, you may not want to convert, because doing so will cause
the traditional IRA to be included in your income, in which case it will
be subject to income tax. You may instead want to keep a traditional
IRA and preserve the tax deferral opportunity. On the other hand, if
you do not need to use the funds for your retirement, and you have
sufficient assets to pay the income tax due upon conversion, you may
want to convert to a Roth IRA and let the new earnings accrue. That
way, your IRA can one day be distributed to your beneficiaries tax-
free.
FACTOR 3: Do you expect your tax bracket to change?

Another factor to consider is whether you expect your income tax
bracket to change during your lifetime. For example, if you have little
taxable income and are currently in the lowest tax bracket, it may make
sense to convert your traditional IRA to a Roth IRA because you will
pay taxes on the conversation at a relatively low rate. However, if you
now have a lot of taxable income and are in a higher tax bracket, you
may want to delay converting until you drop into a lower tax bracket
or not convert at all.
FACTOR 4: How do you feel about RMDs?

A traditional IRA owner must take RMDs every year once he or she
reaches age 70½. But there is no RMD for a Roth IRA until after the
owner’s death. So if you don’t want to take RMDs, a Roth IRA may be
a better choice for you.

122 IRA’S
FACTOR 5: Is it likely that you will want or need to withdraw

the money?
A Roth IRA owner can withdraw all of the funds from a Roth IRA
account tax-free, for any reason, as long as the account has been held
for the greater of five years or until the IRA owner reaches age 59½,
whichever is longer. So someone who converts a traditional IRA to
a Roth IRA at age 40 cannot withdraw the entire converted amount
without penalty until age 59½. This may still make the Roth IRA more
appealing than the traditional IRA, which limits withdrawals. On the
other hand, if the IRA owner is older than 59½ when the traditional
IRA is converted to a Roth IRA, the account owner can withdraw any
growth on the account before the five-year waiting period is up (and
be taxed on those withdrawals). To simplify, if a 60-year-old traditional
IRA holder converts $50,000 to a Roth IRA and two years later it’s
worth $52,000, only the $2,000 increase in the account is eligible for
withdrawal, and that $2,000 will be fully taxable. After the five-year
wait, however, the entire value can be withdrawn tax-free.
So, should you convert your traditional IRA to a Roth IRA? The decision
to convert, as you can see, involves an analysis of many factors, which
will vary from person to person. There is just no simple answer. Smart
Money offers a free calculator than you can use to help you decide if
converting a traditional IRA to a Roth IRA will be beneficial. See http://
nasdaq.smartmoneyuniversity.com. I also recommend that you speak to
a tax or financial advisor if you are considering converting.
IRA’S 123
Liquidate Your IRAs?

Why you may want to cash out
You have a traditional individual retirement account (IRA). You’re
retired. And you want to make the best possible estate planning
choices. Should you cash out now, when all or part of your IRA’s
value will be hit with income tax, to reduce the amount of your assets
potentially subject to estate tax? Or should you leave the IRA in place
until your death, possibly subjecting it to estate tax, but continuing
to defer income tax for as long as you live, except for the required
minimum distributions (RMDs) after age 70½?
One question to ask is which of these two approaches would provide

a greater benefit to those you have named as your IRA’s beneficiaries?
The answer becomes complicated, for a number of reasons. It depends
on your particular financial circumstances and estate tax rules, for one.
I don’t know your situation, and I don’t know how the estate tax rules
will be structured after 2010, which is when the recently enacted estate
tax changes are due to expire. As a result, I can’t give you a one-size-
fits-all answer, other than it would be best to consult a financial advisor.
124 IRA’S
But I can help you get started by going over some of the considerations
that should part of your decision.
First, let’s discuss RMDs. If you don’t need money from your IRA, it’s
nice to think of leaving it in place, to grow tax-deferred until the end of
time, or at least until your beneficiary or his or her beneficiary needs it.
But that’s not going to happen. The U.S. government has made certain
of it by setting up rules that require you, and later your beneficiaries, to
take money out of the IRA – money which is subject to income tax.
Essentially, the rule states that you must begin taking RMDs once you
reach age 70½. And, your beneficiary may also have to cash out your
IRA in as few as five years. I’d go into more detail, but these rules
get quite involved and are dependent upon whom you name as your
beneficiary, and whether you die before or after distributions must
begin. So again, it’s best to consult your financial advisor for more
specific advice.
When making your decision as to whether you should maintain your

IRA’s status or cash it out, it’s also important to consider who your
beneficiary is. If your spouse is your sole beneficiary, your IRA will be
included in your gross estate, but it will not be subject to estate tax as
it will qualify for the marital deduction. And your spouse may have
the ability to roll over your IRA into his or her own IRA or qualified
retirement savings plan and continue to defer income tax. On the other
hand, if your beneficiary is someone other than your spouse, your IRA
will likely be subject to estate tax, assuming that your taxable estate
exceeds the exclusion amount of $1.5 million in 2005. The amount of
your estate exempt from federal estate tax, and the estate tax rate, will
also change over the years, as the following chart shows.
IRA’S 125
Federal Estate Tax Exemption Chart
Year Federal Gift Tax Federal Estate & GST Highest Federal Estate
Exemption Tax Exemption GST Tax Rates
2002 $1,000,000 $1,000,000 50%

2003 $1,000,000 $1,000,000 49%
2004 $1,000,000 $1,500,000 48%
2005 $1,000,000 $1,500,000 47%
2006 $1,000,000 $2,000,000 46%
2007 $1,000,000 $2,000,000 45%
2008 $1,000,000 $2,000,000 45%
2009 $1,000,000 $3,500,000 45%
2010 $1,000,000 Unlimited N/A
2006 $1,000,000 $1,000,000 55%
The result of the latter isn’t necessarily bad for a few reasons. While
your beneficiary may owe income tax on the IRA assets, he or she
may be in a lower income tax bracket than you were, and may thus
owe less than you would. If your estate is larger than $1.5 million and
subject to estate tax, the amount of income tax due may also be offset
by a portion of the estate tax already paid on the IRA. It’s called “net
unrealized appreciation” and it’s a tax deduction on inherited IRAs
that many people miss. Or, if you have assets in addition to your IRA
when you die, your executor could pay the estate taxes due on the IRA
from funds other than those in your IRA.
Finally, when you meet with your financial advisor, you’ll want to
consider your IRA in the context of all of your assets. For example, if
you have few other assets besides your IRA, you may need to tap into
your IRA if you become seriously ill. Or, if you have substantial assets
and your adjusted gross income is below the $100,000 limit, you may
want to consider converting a traditional IRA to a Roth IRA.
126 IRA’S
You’ll have a much clearer picture of your options and you’ll be able
to decide how best to pass your IRA on to your heirs after a thorough
analysis has been conducted for your particular situation, and only a
qualified financial advisor can do that. But hopefully, I’ve been of some
assistance.
IRA’S 127
Beneficiaries and Required

Distributions
How your designations affect your heirs
With the markets performing well again, many retired investors who
have growth or income producing investments are finding themselves
less dependent on their individual retirement accounts (IRAs). As a
result, they’re looking for ways to pass some or all of their IRA assets
on to their heirs.
If this scenario applies to you, it’s important to remember two things.

First of all, having one IRA account may not be the best choice. Secondly,
how you designate the required minimum distribution (RMD) to be
calculated for each account is important. The RMD matter pertains to
Roth IRAs as well as traditional IRAs. While the original owner of a
Roth IRA is not required to take minimum distributions, RMDs are
required of Roth beneficiaries.
128 IRA’S
If you have beneficiaries whom you would like to treat differently,

splitting your IRA into a number of accounts may be advantageous.
If there’s a significant age difference among the beneficiaries, setting
up separate IRAs can enable those who are younger to maximize their
potential for tax-deferred growth. Then, upon your death, the RMDs
can be calculated for each beneficiary based on his or her own life
expectancy instead of the life expectancy of the oldest beneficiary,
as would be the case if there was one account. Younger beneficiaries
would then be allowed to take smaller distributions, reducing their
current taxable income and leaving more in their accounts to grow
tax-deferred.
You can divide up your single IRA in any way you choose – in equal
amounts, or leaving more to some beneficiaries than to others in their
own separate accounts. You can also select different investments for
each account – perhaps more aggressive stock funds for younger
beneficiaries who can afford a higher level of risk and conservative
bond funds for older beneficiaries who may need income.
Once you have split your single account into separate accounts, one for
each beneficiary, why should it matter how they are set up? Whether
you have one IRA account or several, it’s important to think about how
your RMD designations will affect the RMDs of your beneficiaries.
Your IRA’s RMD will depend on the standardized mortality tables

established by the Internal Revenue Service (IRS) and on the designated
method of calculation you choose. While the IRS defines who can use
which designation, it’s up to you to make a selection. Your choices are
as follows: 1) the single life expectancy of the IRA holder, 2) the joint
life expectancy of the IRA holder and his or her spouse beneficiary,
and 3) the joint life expectancy of the IRA holder and his non-spouse
beneficiary. Let’s take a brief look at each one.
Single life expectancy – This designation generally provides for the

largest distributions and highest potential taxable income, so it’s most
appropriate for IRA holders who plan to withdraw most of their IRA
during retirement. If you’re already into retirement, this selection is
probably not for you.
IRA’S 129
Joint life expectancy with a spouse beneficiary – Using this designation

can reduce the IRA holder’s required minimum distribution and current
taxable income, and increase the potential for tax-deferred growth.
Also, upon the IRA holder’s death, the spouse beneficiary generally
has more distribution timing options.
Joint life expectancy with a non-spouse beneficiary – This may be an even

better selection. Because the beneficiary may be a child or grandchild,
this designation may be most appropriate for IRA holders who wish to
maximize tax-deferred growth and leave a legacy for their heirs.
In general, your selection of an RMD designation is tied to your marital

status (and should be updated if that changes). Someone who is single,
for instance, usually must choose “single life expectancy.” However,
there are possible deviations from the standard IRS guidelines. There
are also other special rules, like those that apply to non-spouse
beneficiaries when determining life expectancy.
Suffice it to say that the matter of designating RMDs and IRA

beneficiaries is a complex subject, with too many details to fully discuss
here. Just be aware of the potential for problems when setting up your
IRA.
The IRS is very unforgiving if you should make a mistake. There have
actually been cases where an improperly filled out beneficiary form led
to a lawsuit after the IRA owner’s death. One lawsuit that I know of in
particular is still racking up thousands of dollars in legal fees, and will
likely result in the beneficiary losing at least half of the original IRA’s
value once tax matters are settled. So before you make any decisions
about your IRA accounts and beneficiaries, it’s a good idea to consult
with your financial advisor.
The tax and legal information in this article is merely a summary of my understanding and
interpretation of some of the current laws and regulations and is not exhaustive. Investors
should consult their legal or tax counsel for advice and information concerning their particular
circumstances.
130 IRA’S
Extending the Life of Your IRA

Tax deferral for the next generation
I meet with a number of clients who have individual retirement
account (IRA) balances that they don’t need to tap into for retirement
income and they often ask: What is the best way to maximize tax-
deferred growth and create an income stream for my beneficiaries?
The answer is to establish what’s called a “stretch” or “generational”
IRA. This isn’t a different type of IRA, like a Roth. It’s a traditional IRA
split into separate accounts for each beneficiary. To illustrate, let me
give you an example.
Let’s create John Doe*, an investor with two children, 45-year-old Bill
and 35-year-old Denise. And let’s say that John Doe has a traditional
IRA. At age 70, right on schedule, John starts taking his required
minimum distributions (RMDs), and he continues taking them until
he dies at age 85.
Since John’s IRA is a single account, John Doe’s RMDs would begin
at $3,650 and gradually rise to $10,766 at the time of his death. Then
IRA’S 131
the IRA would pass on to his beneficiaries, and their RMDs would be
calculated based on the single life expectancy of the oldest beneficiary.
In this case, that’s Bill. He’s 60 years old and his single life expectancy
is another 19.81 years, so his RMDs would be $6,611. These distribu-
tions would be split evenly between Bill and his sister, Denise, because
they are both John’s beneficiaries. The problem is that Denise is 10
years younger than Bill and her life expectancy is 31.80 years, so she
may have to accept income more rapidly than she desires. Wouldn’t it
be better if Denise could leave more of that money in the IRA and let it
grow, tax-deferred, until she really needs it? Well, she can.
As an alternative to holding a single account, John Doe could set up

two separate IRA accounts, one for Bill and one for Denise. If the IRA
custodian won’t do so, John Doe can split his IRA assets by transferring
them into two separate IRAs. One IRA would list Bill as a beneficiary
and the other one would list Denise. This must be done before John
Doe’s death or by September 30 of the year following his death.
What would such a split accomplish? Let’s review the numbers and
see. Splitting the IRA into two accounts would allow each beneficiary
to stretch the IRA RMDs over his or her own life expectancy. So, with
this option, John Doe’s annual distributions would start at $1,825 per
account ($3,650 total, just as before) and gradually rise to $5,383 per
account (the same $10,766 total) at the time of his death in 2017. So
nothing changes for him. But look at what happens when John Doe
dies. Bill would start receiving distributions of $3,306 and Denise
would receive $2,422. That may be much better for Denise because
she’ll be able to leave more money in the IRA, where it will continue
to grow tax-deferred.
*Assumptions: $100,000 IRA with a hypothetical annual growth of 8%. Original owner
is age 70 at start, son is age 45, and daughter is age 35. Owner dies at age 85 in 2017, son
at age 75 in 2032, and daughter at age 90 in 2057. Distribution amounts are based on life
expectancy, not actual life span. The examples above are hypothetical and for illustrative
purposes only. They are not meant to represent the performance of any particular product.
**Mortality tables vary in their life expectancy calculations. Statistics are taken from the
Social Security Administration’s Period Life Table, 2002, www.ssa.gov/OACT/STATS/
table4c6.html, Bill’s and Denise’s life expectancy would be more accurately based on charts
at the time of their father’s death in 2017.
132 IRA’S
Create Your Own

Private Pension Plan
Income you can’t outlive
Many financial advisors promote the idea of a “stretch” Individual
Retirement Account (IRA). And retirees generally buy into it, leaving
their IRAs to their kids, who will supposedly “stretch” the inherited
IRAs over their own life expectancies. But it usually doesn’t work that
way.
Often, the next generation will cash out the IRA upon inheritance,
which can result in significant tax consequences. In fact, 30%-70% of
the IRAs left to children could easily wind up going to Uncle Sam,
thanks to income tax and possibly estate taxes when they cash out.
(An IRA left to a spouse is another story, but the concept I will describe
here works well for whomever is the beneficiary of your IRA.)
You do have another option, which I like to call the “IRA pension,” and
here’s how it works.You invest IRA money in a “personal pension”and
IRA’S 133
in return receive a generous, guaranteed monthly income for the rest

of your life. Whether you’re around for a few more years or many, you
can count on the income always being there. The payment amount you
will get from this pension depends on a number of factors, but using
the average median return for those whom I’ve set up this pension
plan for thus far, expect to receive around 7% for the rest of your life,
never to change regardless of market and/or interest rate conditions.
Does this sound good so far? Now, you may be asking what happens
to the money used to finance your “pension”. The answer is you
don’t have access to it during your lifetime. But with my strategy, when
you die, it all goes back to your family tax-free.
Let’s take a closer look at the engine that drives this pension, the
machinery that makes this strategy run.
Inside your IRA, you transfer your IRA assets to an immediate annuity,
which is essentially an insurance vehicle that provides you with
a guaranteed income for the rest of your life. The transfer is a non-
taxable event; only the income that you receive from this immediate
annuity is taxable. From the annual income you receive from this IRA,
you “sweep” the premium payment for a life insurance policy that has
a death benefit equal to the amount you initially invested into the
immediate annuity. The funds that remain after you pay for the cost
of the life insurance is your spendable income. (I am not including tax
analysis in this calculation, which is certainly important to weigh and
factor in.)
To make things easier, let’s look at a hypothetical example for one

particular individual for whom I recently made this arrangement. In the
“real world” much more money was used, but for simplicity I’m using
$100,000 to help you understand the concept. Remember, everyone is
different and there are a variety of factors that will ultimately determine
exactly how your plan would work, and if it makes sense for you to
consider it.
134 IRA’S
Let’s say you’re 77 years old, and inside your IRA you invest $100,000
in an immediate annuity and receive a lifetime income stream of
$13,000 per year. There’s only one problem: If you die tomorrow, the
original $100,000 investment will be gone forever. So every year you
“sweep” $6,000 from your $13,000 annual income and use it to pay
the premiums for a life insurance policy with a $100,000 death benefit.
You’ll then be left with an annual income of $7,000 per year, and
because of the life insurance component, when you’re gone, your heirs
get the $100,000 back tax-free – the same amount originally used to
finance your “IRA pension.”
Now, if you recall, I mentioned that most kids who inherit an IRA will
cash it out, and they will lose anywhere from 30%-70% of the IRA’s
value to taxes. With this solution, you just gave yourself a guaranteed,
lifelong income stream of 7% from the amount you invested in the
annuity and you left the inherited value of your IRA fully intact and
tax-free. It’s not a bad deal.
There are, however, a few important things you should keep in mind:
1. IRAs left to spouses typically get rolled over and simply become
part of their IRA, which leaves your spouse with a tax burden
when taking out required minimum distributions (RMDs) and
then passes the taxable IRA to the next generation. Wouldn’t it be
better just to leave the IRA tax-free to whomever gets it next?
2. The locked-in return will depend on three primary factors:Your age,

your health, and interest rates at the time the plan is implemented.
I’ve created plans that have returned (after cost of life insurance)
anywhere from 5%-15%. Typically, the older your are, the better
this plan looks.
3. The income being paid out of your IRA will satisfy all RMDs for the
rest of your life. The only exception is if you have other IRAs not
incorporated into this strategy. In that case, the RMDs would have
to be figured out for all other IRAs.
IRA’S 135
4. Many retirees think the cost of life insurance will be too high for
this strategy to make sense because their health is poor or they are
too old. While that’s a good point, consider that if the cost of life
insurance is high because of poor health, the immediate annuity
payout can very likely be higher as well, and thus the portion
remaining for income will still fall within my median 7%. As long
as you can qualify for some level of life insurance – and granted,
some people simply cannot – the numbers could work out quite
well.
5. A key consideration: If you “turn your IRA into a pension,” you no

longer have access to the funds you invest, just the income coming
from the IRA. To solve that problem, I recommend people use only
portions of their IRA and/or have enough savings outside the IRA
to eliminate this concern. For the plan to work, you must have
additional ample resources for a number of reasons, including
but not limited to: An inflation hedge, emergency cash needs,
unforeseen emergencies, health care issues, and a variety of other
factors.
6. The life insurance’s death benefit does not always have to equal
the amount used to finance the immediate annuity. Simply put,
the less death benefit returned to your family, the more income you
will receive. So using my prior example, instead of leaving $100,000
to the kids, say $80,000 is left to them through life insurance. The
remaining income left for you to spend might then very well go up
from 7%-9%.
Some of the clients for whom I have designed these plans assume their
children will cash out the IRA. Let’s suppose, as an example, I have
$100,000 in my IRA. I am pretty sure the kids will cash it out when
inherited, and through a tax analysis, I realize the after-tax amount
they will receive will be somewhere around $70,000. So instead of the
insurance policy returning the full $100,000, I could leave them an
insurance policy worth $70,000, which would be the after-tax amount
they would have received through a direct inheritance. Yet what this
136 IRA’S
strategy does for you is lower your cost of insurance, thereby leaving
you with a higher rate of return on your “pension.”
As you can see, there is no science to the IRA pension. It can be

designed and implemented in any number of ways. As an example, on
the flip side of what I just mentioned, I’ve also structured some IRA
pensions so that the amount that heirs receive from the life insurance
policy is more than the amount used to fund the pension. The way the
plan is ultimately designed really depends on only one thing – you.
What are your goals? How much income do you need? How much
do you want to leave to your children? All these elements need to be
explored so that you are happy with the plan.
The bottom line is that many retirees only take the RMDs out of their
IRAs, and most kids cash out the IRA and end up paying lots of tax
upon inheritance. So why not create an attractive income stream you
cannot outlive and leave the entire value of the IRA tax-free to your
family? After all, for income, where else can you get a 7% or better
guaranteed rate of return on your IRA money and leave the principal
tax-free to your heirs? That’s what this is all about. And with further
investigation, this could be one of the greatest gifts you ever gave
yourself and your family.
IRA’S 137
Self-Directed IRAs
You can even invest in real estate
Most investors believe that their only individual retirement account
(IRA) investment options are mutual funds, stocks, and bonds. But
believe it or not, you can also invest your IRA assets in real estate. Yes,
real estate. Whether it’s a fixer-upper or timberland, if it’s property, you
can invest in it, with a few limitations.
The investment vehicle that allows this option is called a“self-directed”

IRA. As with traditional IRAs and Roth IRAs, these self-directed
accounts enable their owners to pursue a wide variety of investments,
including single-family homes, urban real estate developments, farms,
liens, and mortgage notes. You can even use the money to start a small
business. The only things you can’t invest in are life insurance and
collectibles.
Setting up a self-directed IRA is relatively simple. You open an account

with a custodian or administrator that specializes in self-directed
IRAs. Two of the larger ones are Entrust Group, Inc., based in Oakland,
138 IRA’S
California, and Pensco Trust Company, based in San Francisco,

California. You transfer assets from your traditional IRA to the new
self-directed IRA and then seek out investments such as real estate.
When you’re ready to make a purchase, you simply tell your custodian
to cut the seller a check.
Of course, self-directed IRAs aren’t free. Costs typically include an

annual custodial fee and transaction fees. Entrust and Pensco, for
example, charge $50 to open accounts. In addition, Entrust charges
an annual record-keeping fee based on asset size that can range from
$125 to $1,750. Pensco also charges an annual maintenance fee which
runs from $150 to $1,000.
But even the fees aren’t stopping a lot of people from investing in
self-directed IRAs. According to the Wall Street Journal, Entrust’s self-
directed IRA assets have quadrupled to $2 billion in the past five years.
And Pensco’s self-directed IRA assets have doubled to nearly $1.5
billion in the past 15 months.
There is one thing to keep in mind if you’re interested in using IRA

assets to invest in real estate: The limitations. A lack of understanding
about those limitations makes self-directed accounts “accidents
waiting to happen,” according to the Wall Street Journal. What’s the
biggest risk? Something that’s usually referred to as “self-dealing.”
According to Internal Revenue Service (IRS) regulations, an IRA

is supposed to provide for your retirement, not your current living
expenses. So you can’t benefit now from an investment you make in
real estate via a self-directed IRA. That means you can buy property
and rent it out to a stranger, but you can’t buy property and live in it
yourself, or rent it out to a family member. If you do, the IRS could step
in and disqualify the IRA, resulting in a large tax bill as well as some
penalties for account holders who are younger than age 59½. In other
words, you could lose your IRA.
IRA’S 139
How do you avoid getting into a mess like that? Get a good financial
advisor to guide you through the process of setting up and administering
a self-directed IRA. He or she can help you obtain advance approval
from the Labor Department (which oversees pension plans) on any
transaction which might be questionable. An advisor can also help you
keep your traditional IRA assets separate from your self-directed IRA.
In that way, just in case you do make a mistake, you won’t be putting
your entire retirement nest egg in jeopardy.
140
SEVEN
TAXES CHAPTER 141
Understanding Tax Efficiency

Tips to save you money on April 15
Taxes. The word alone is enough to make people cringe. We hate to
pay them, and always look for ways to reduce them, but unfortunately,
there’s just no way to completely get around them, legally, that is.
Good financial planning strategies that can help you lower your tax
burden include taking advantage of tax law changes and even paying
attention to your investment choices. Then, when you get your tax
refund, deciding what to do with that money can impact your financial
future too.
Many investors haven’t heard of the term “tax efficiency”, but it’s one
that you might want to become familiar with because it could save you
some money come tax time each year. A tax-efficient investment is
one that produces favorable tax consequences. For example, a 401(k),
variable annuity, or other investment whose taxes can be deferred
might be considered tax-efficient. A municipal bond fund – whose
income is free from federal and state taxes – might also be considered
tax-efficient.
142 TAXES
Some mutual funds that invest in stocks and non-municipal bonds

can also be considered tax-efficient, at least those that “turn over” or
sell fewer of their portfolio holdings. That’s because when mutual fund
portfolio managers buy and sell securities often, it translates into more
taxes to be paid by shareholders. (Even if you don’t sell or exchange
your fund shares, you must pay taxes on distributions you receive from
the mutual fund itself.)
You can determine a fund’s turnover rate easily because the Securities
and Exchange Commission (SEC) requires every mutual fund to
publish this number. Typically, it can be found in the financial high-
lights section of annual and semiannual shareholder reports, as well
as in prospectuses.
Although portfolio turnover is a good indicator of tax efficiency, it’s not

the sole measure. Portfolio turnover alone doesn’t reflect the type of
selling activity. It doesn’t tell you whether securities were sold at a gain
(the result could be a taxable capital gains distribution to shareholders)
or a loss (there may be no additional tax, and a loss could even be
used to offset capital gains). It also doesn’t tell you whether capital
gains were long-term or short-term. That’s important because gains
are taxed differently based on how long the security was held.
If you want an objective measure of a fund’s tax efficiency, you can

look at its tax efficiency ratio, which is calculated by dividing its tax-
adjusted return by its pre-tax return. This is the percentage of the total
return that an investor keeps after taxes. The higher the ratio, the more
tax-efficient the fund has been.
The difficulty is that all funds do not publish this ratio. One helpful
hint: Tax efficiency ratios for mutual funds are available on Morningstar.
com. (Note that a few steps are necessary to get to this information. On
the Morningstar home page, enter the name of the fund or its ticker
symbol in the box in the upper left section of the screen. When the
fund information appears, click on the light gray “Tax Analysis” tab on
the left side of the screen.)
TAXES 143
You can expect to see some trends in tax efficiency by type of mutual
fund. Value style stock funds, for instance, tend to have relatively low
portfolio turnover rates. That’s because their strategy often demands
holding on to a stock until the market recognizes its value, which could
be a long time. Stock index funds also tend to have limited portfolio
turnover because the stocks that make up their respective indices
change infrequently.
So as you prepare for next tax season, you may want to keep the tax
efficiency of your investments in mind. While you shouldn’t base your
investing solely on tax factors, in light of ongoing tax law changes, taxes
are just one more thing to consider when reviewing your portfolio.
144 TAXES
Taking Advantage
of the 2003 Tax Act
Many investors are still missing out
The Jobs and Growth Tax Relief Reconciliation Act of 2003 may be
old news, but a lot of investors aren’t fully taking advantage of it. Are
you?

This act included the third largest tax cut in history, and if you invest
in mutual funds, you may benefit. Certain types of mutual funds in
particular are more likely to pass on tax savings as a result of the
act than others. If you understand how that is so, you too can take
advantage of the new tax rules by investing primarily in those types of
funds and boosting your portfolio’s return potential.
Which mutual funds are the biggest beneficiaries of the 2003 tax act?
Funds that pay relatively high dividends. But before we explain why,
let’s go over what dividends are.
TAXES 145
As you know, the main goal of any business is to earn a profit for its
owners. When a company earns a profit, some of this money is typically
reinvested in the business (and is referred to as retained earnings) and
some of the profits are paid to shareholders as a dividend. If you own
stock in the company, you’ll receive the dividend directly. If you own
shares of a mutual fund, the fund will receive the dividend from the
stock and in turn distribute it to you.
So why is the 2003 tax act good for funds that pay relatively high
dividends? Because dividends, which were previously taxed at ordinary
income rates (currently 25%, 28%, 33%, and 35%), are now taxed at
a special lower rate of 15% (or 5% for those in the two lowest tax
brackets, which many retirees find themselves in).
Other mutual funds that have benefited from the 2003 tax act are those
that tend to produce long-term capital gains. That’s because long-term
capital gains, which used to be taxed at 20% (or 15% for those in the
lowest tax brackets), are also now taxed at 15% (or 5 % for those in the
lowest tax brackets).
It may make sense, then, to invest the equity portion of your portfolio
in stock funds that do two things. First, they should focus more on
dividends than on growth, which will allow you to take advantage
of the lower tax rate on dividends. Second, they should have little
portfolio turnover, so you can also benefit from the lower tax rate on
long-term capital gains.
Mutual funds with those characteristics – focusing on dividends and

turning over less of their portfolios – may be value style funds. Value
funds invest in stocks of larger, more established companies, and those
companies tend to use their profits to pay dividends to shareholders
rather than reinvesting it for their own growth. They also are inclined
to invest in out-of-favor stocks and hold on to them for long periods,
which results in the lower long-term, rather than short-term, capital
gains taxes.
146 TAXES
Stock index funds – those that track a particular index (such as the
Standard & Poor’s 500 index) — are another category of mutual funds
that typically have lower portfolio turnover and therefore should
benefit from the 2003 tax act. That’s because the stocks that make up
an index, and thus the fund’s portfolio, change infrequently and incur
few capital gains.
Less desirable for investors concerned about taxes will be funds that
have high portfolio turnover as they’ll tend to have a higher level of
short-term capital gains, which are still taxed at ordinary income rates.
(Remember, even if you don’t sell or exchange your fund shares, you
must pay taxes on the distributions you receive from the mutual fund
itself.) Many growth funds, particularly those that focus on sectors
such as technology and health care, are examples of funds with higher
portfolio turnover and would thereby cost you more in taxes.
TAXES 147
The New Tax Law

Mostly good news for investors
President George W. Bush has signed the Tax Increase Prevention

and Reconciliation Act (TIPRA) into law, and that’s mostly positive
for taxpayers. Capital gains taxes, Roth individual retirement accounts
(IRAs), small business deductions, and the alternative minimum tax
(AMT) are several of the areas that were affected.
Here are some of the highlights.
Good news! Long-term capital gains rates are extended. The biggest
and best news in TIPRA is the extension – through 2010 – of the
current federal tax rates for long-term capital gains and qualified
dividends. Qualified dividends are those which: 1) were paid by a U.S.
corporation or a qualified foreign corporation; 2) meet the holding
period requirement – you held the stock for more than 60 days during
148 TAXES
the 121-day period that begins 60 days before the ex-dividend date,
which is the first date following the declaration of a dividend on which
the buyer of a stock will not receive the next dividend payment but
the seller will (it simply means that as long as you are the shareholder
of record when a company declares a dividend, you will be paid the
dividend even though you sold the stock); and 3) are not excluded by
the Internal Revenue Service (IRS) for various reasons. The tax rates
for long-term capital gains and qualified dividends will remain at 15%
through 2010. (Taxpayers in the 10% and 15% brackets get an ever
better deal, paying 5% in 2006 and 2007, and 0% from 2008 through
2010.)
Good news! More Roth conversions starting in 2010. Investors who

convert a traditional IRA to a Roth IRA can usually save on taxes at the
time they begin taking withdrawals, given the fact that Roth earnings
are not taxed (although withdrawals made prior to age 59½ are subject
to a penalty). In the past, investors have been ineligible for the Roth
conversion in any year in which their modified adjusted gross incomes
exceeded $100,000. The TIPRA eliminates this restriction starting in
2010. But don’t get too excited yet: Congress could change its mind
before then.
Good news! Temporary help for the AMT. Ah, the much-dreaded
alternative minimum tax (AMT). The AMT is a tax system with its own
set of rates and its own rules for deductions, which are usually less
generous than the regular rules. Individuals with annual incomes above
$75,000 and larger write-offs are often hit by it. The TIPRA reduces
the odds that you will be hit. First, it increases 2006 AMT exemptions
(deductions claimed when calculating whether you owe the AMT or
not) to $62,550 if you’re married and file jointly (up from $58,000 for
2005); $31,275 if you’re married and file separately (up from $29,000
for 2005); and $42,500 if you’re single or the head of a household (up
from $40,250 for 2005). And, it lets taxpayers use their personal tax
credits (such as for dependent care or education) to reduce both their
regular 2006 tax bill and their AMT 2006 tax bill.
TAXES 149
Good news! Section 179 deduction rules are extended. If you own a
small business, you’re probably familiar with Section 179, which allows
many small business owners to deduct the full cost of most equipment
and software in the year it’s purchased. The maximum deduction,
which is $108,000 for 2006, was scheduled to drop to $25,000 after
2007 but the TIPRA extended the current rules through 2009.
Bad news. More dependents exposed to the ”kiddie” tax. Under the
“kiddie” tax rules, a dependent child’s unearned income (typically
from investments) can be taxed at the parent’s federal income tax rates.
That’s bad news because the parents’ tax rates can be much higher than
the child’s – 35% (or 15% for long-term capital gains and dividends,
as mentioned above). Before 2006, this tax only applied to dependent
children who had not reached age 14 by year-end. Starting in 2006,
the tax applies to dependent children who have not reached age 18 by
year-end. However, you can breathe one sigh of relief: The tax applies
only to unearned income in excess of $1,700.
Hopefully, you will find the TIPRA to be of some benefit.

150 TAXES
Reducing Capital Gains

and Estate Taxes
Two trusts that can help

How would you like to lower your capital gains and estate taxes at the
same time? Yes, it can be done through a charitable remainder trust
(CRT) or a private annuity trust (PAT). Setting up either of these trusts
will allow you to reduce your estate taxes. But hardly anyone knows
that depending upon which you choose, you will also be able to defer
paying capital gains taxes on highly appreciated assets – such as real
estate and stocks – or avoid paying them altogether.
With the CRT, you make an irrevocable gift of assets (such as appreciated
securities, real estate, or cash) to a trust. For the remainder of your life,
you (or a party you designate) receive the investment income from the
assets held within the trust. Upon your death, the principal value of
the assets is transferred to your designated beneficiary, which must be
a recognized non-profit organization.
TAXES 151
People typically shy away from the CRT because while the donors
receive income for life, the “donated” asset gets left behind to charity,
which disinherits heirs. To solve this problem, many people who do
set up a CRT “sweep” some of the income off the income stream and
use it to pay for a life insurance policy that replaces the amount of the
donated asset tax-free upon their death.
There are a number of benefits to setting up a CRT, but the three major
reasons pertain to reduced taxation. First, you won’t pay any capital
gains tax on the appreciated assets in the trust, making CRTs ideal for
assets with a low-cost basis but high-appreciated value, such as real
estate. Second of all, contributions to a CRT are considered charitable
contributions, so they qualify for an income tax deduction (and any
deduction not taken in the year of contribution can be carried forward
for the next five years). And third, the value of the assets held in a CRT
trust is considered “outside of your estate” by the Internal Revenue
Service (IRS), meaning it’s excluded from the calculation of your estate
taxes. This could reduce your estate tax rate by as much as 46 cents of
every dollar, given current estate tax rates.
To summarize the workings of a CRT, when including life insurance as

part of the plan, the donor: 1) avoids capital gains tax when donating
the asset and selling it; 2) gets income for life from the CRT, which has
its own tax breaks given the donation of the asset itself; 3) removes the
asset from the estate, which would lower the estate tax, if there is any;
and lastly; 4) replaces the donated asset tax-free to heirs through the
life insurance policy.
It’s really not a bad deal, and it is something that certainly should at
least be considered by those who are planning to sell highly appreciated
assets and have lots of taxes awaiting them.
A PAT is another type of trust that’s similar to a CRT. With a PAT, you
transfer the desired assets into the trust, the assets are then sold, and
the proceeds are used to purchase an annuity. As with a CRT, the assets
held in a PAT are excluded when calculating your estate taxes. But part
of each payment you receive from the PAT will contain a portion of the
152 TAXES
capital gains which were due on sale. So while a CRT eliminates the
capital gains tax, the PAT spreads them out over the rest of your life.
This latter point may make the PAT less desirable than the CRT. Yet
some people consider the PAT a better option because over time, the
investor and the investor’s family receive all proceeds from the sale
of the asset. Thus, if you create a PAT, upon your death the asset will
be removed from your estate and your heirs will receive whatever
portion of the asset remains, free of estate taxes, gift taxes, generation-
skipping taxes, and transfer taxes. However, your heirs will have to pay
any remaining capital gains tax due.
How much income can you receive from a CRT or PAT? That depends.
With a CRT, for example, your income will be based on the amount
of income your assets generate while inside the CRT, as well as the
“payout percentage”, or the size of the payments you choose to receive.
The IRS requires CRTs to distribute a minimum of 5% of the net fair
market value of its assets annually. If you don’t need income from the
CRT in one year, you can defer it through a “makeup provision”, but
the CRT’s net distributions must eventually equal 5%. This means that
you don’t have to start taking income right away. In some cases, if you
defer taking the income, you can potentially take more income out
later than if you would have taken the distributions in the first place.
One caveat here: The higher the payout percentage, the lower your
charitable income tax deduction will be, so you’ll want to talk to an
advisor about striking the right balance between the two.
I would strongly urge anyone considering a CRT or PAT to speak with a

qualified estate planning attorney. Although the concepts as presented
here are somewhat simple, the complexity of the taxation, along with
one’s estate and income requirements, all need to be well factored into
the decision making process. This is not run of the mill type planning,
and it definitely takes an experienced individual to assist you.
That said, don’t be shy. A CRT or a PAT can be an excellent choice

in helping you reduce taxes, create lifetime income and of most
importance to some – leaving a legacy behind.
TAXES 153
How Will You Spend

Your Tax Refund?
Five things financially savvy people do
According to a recent USA Today analysis of Internal Revenue Service

(IRS) records, taxpayers overpaid their federal income taxes by 29%
in both 2003 and 2004. And the overpayment trend seems to be
continuing in 2005. Tax refunds are currently up 4% from 2004, with
an average 2005 tax refund of about $2,400.
Many people use their tax refund money for a vacation or a down
payment on a new car, but not the financially savvy. Here are five
smarter things you can do with your tax refund instead.
1. Invest the money in an IRA.

As they say, the early bird catches the worm. By investing earlier in
an individual retirement account (IRA) this year, you gain the full
benefit of tax-deferred compounding. As a hypothetical example,
let’s assume you invest $3,000 in an IRA each year for the next 10
154 TAXES
years, and the IRA grows at 8%, compounded quarterly. If you make
the contribution at the end of each year – in December – you’ll end
up with $166,385. But if you make the contribution sooner – say, in
April – you’ll end up with $181,281. That’s because by making the
contribution earlier in the year, you’ll gain additional months of
compounding.
2. Make an extra mortgage payment.

Your mortgage will probably be the largest expenditure of your
lifetime and paying even a little bit extra towards it each year can
add up to substantial savings. For example, if you buy a $150,000
home and take out a $120,000 mortgage for 30 years at an interest
rate of 9%, at the end of that 30 years, you will have paid over
$227,500 in interest alone – in addition to your original $120,000
mortgage. Your total expense will be more than two-and-a-half
times the cost of your home. Making even one extra principal
payment every year can help lower your total interest charges. Or,
if you could pay an extra $100 each month, you’ll save over $82,000
in interest – and pay off your mortgage nine years and two months
earlier! Can’t afford $100 a month? How about an additional $50
a month? That will cut your payment time by five years and seven
months and save you $52,000. An extra $25 will shave off three
years and three months, saving you $30,000. And as little as an
extra $10 a month will cut your mortgage payment time by one
year and save you $13,500.
3. Pay off your credit card balances.

The principle above applies to interest on consumer loans or any
other kind of debt repayment, including credit cards. The national
average for credit card debt is $7,000. At an interest rate of 18%, it
could take over 29 years to pay that debt off. That’s almost as long
as it takes to pay off a typical home mortgage! And the interest
paid on the credit card account would be around $18,400 – almost
three times the original debt! Paying the debt off, or even paying it
down, could save you a lot of money.
TAXES 155
4. Hire a financial advisor.

A bigger refund isn’t necessarily a good thing. Getting a refund
means you overpaid on your taxes over the course of the tax year,
which means you’ve essentially loaned money to the government
– interest free. A financial advisor can help you better plan so you
can keep more of that money in your pocket throughout the year.
5. Give your child or grandchild a gift that can last a lifetime.

Each state has adopted a Uniform Gift to Minors Act (UGMA)
or a Uniform Transfer to Minors Act (UTMA). These acts allow
individuals – such as parents, grandparents, other relatives, and
even friends – to set up a custodial account for the benefit of a
minor. Let’s assume you’d like to help your 10-year-old grandson
David save for college, so you start investing $200 per month, or
$2,400 per year for David until he starts college at age 18. With a
hypothetical average annual return of 8%, David will have $26,541
in his account when he reaches age 18. If David earns his own
college money or gets a scholarship, and the UGMA/UTMA account
is left untouched until he reaches age 65, he will have $832,882 in
his account (again, assuming the investment continues to grow at
8% each year for 47 years).
So, as you can see, what may seem like little things can add up in a big
way when it comes to your money. Long-term, you will also be further
ahead financially than if you bought that new boat or car, and you
won’t have the payments to keep up with either.
156
EIGHT
ECONOMY CHAPTER 157
Not Concerned
about the Federal Budget?
The deficit: Why you should care
You’ve looked forward to retirement for years. You’ve planned and
saved so you’d have plenty of money in addition to what your Social
Security check would cover. But wait! A day of reckoning is coming
and your retirement could be in jeopardy. Yes, you read that right. At
any point, the economy could cause the federal government to make
changes in policies that could affect your spending power.
Many people think they don’t need to pay attention to what happens
with the U.S. economy once they’ve retired, and as long as they have
money in the bank. What they may not realize is that even after they
retire, economic issues affect just about everything related to their
money – from grocery store prices to the value of their investments. If
you want to continue to have a smooth ride through your retirement
years, you need to keep an eye on inflation, interest rates, and other
158 ECONOMY
economic factors in case you’ll need to make adjustments to the

components that make up your retirement vehicle.
The U.S. budget deficit is just one aspect of the economy, and one of the
most troubling. Just four years ago there was a record federal budget
surplus – that is, the government took in more money (mostly in the
form of tax dollars) than it needed to run its programs. But now there’s
a federal budget deficit, or in other words, a shortfall of government
funds. And it’s getting worse. The Bush administration has estimated
that the federal budget deficit will reach a record $521 billion this year,
or 4.25% of the total economy.
Think that’s no big deal? Think again. According to Federal Reserve

Chairman Alan Greenspan, the federal budget deficit is more
problematic than any other economic issue in the United States,
including the soaring trade deficit and record levels of household debt.
Why is this such a problem? The shortfall in government funds has
occurred just before a huge portion of the population will need those
funds most – the baby boomers are retiring.
The “baby boom”occurred from January 1, 1946 to December 31, 1964.

During that period, the birth rate in the United States skyrocketed.
More than 77 million babies who were born over those years – called
baby boomers – will start becoming eligible for Social Security and
Medicare benefits in 2008. But if there’s a federal budget deficit, the
Social Security and Medicare wells could run dry. The government
could be forced to say,“Sorry, we miscalculated. You’re on your own”.
The Bush administration says it plans to handle the problem by cutting

the federal budget deficit in half over the next five years, before the
onset of shortfalls hit Social Security and Medicare. But come on,
governments aren’t known for their ability to spend less money.
Greenspan, who also isn’t convinced that the Bush administration’s
plan will work, has even suggested raising the retirement age or scaling
back annual cost-of-living adjustments for Social Security.
ECONOMY 159
That’s scary stuff. However, I tell my clients they have an option: Plan
now. Adjust your finances while you can, rather than waiting until you
retire to see if you get the benefits you’re expecting. You may think it’s
too late to start investing, but the power of compounding can work in
your favor.
What is compounding? To explain, let’s say you make a one-time

deposit of $1,000 into an investment account that returns 10% and is
compounded annually. At the end of the first year, you’ll have $1,100
– the original investment of $1,000 plus the $100 you’ve earned. At
the end of the second year, you’ll have $1,210 – the $1,100 you started
the year with and $110 of “compounded” earnings. But that’s just the
beginning. Each year, compounding will increase your investment
even if you don’t contribute another penny. Eventually, the earnings
on earnings could exceed the earnings on your original investment.
Now, let’s use compounding in a real life example. Say you were born
in the middle of the baby boom years, in 1955. You’ll be 65 in 2020,
which means you have about 15 years until retirement. What happens
if you start investing $300 a month in a tax-deferred account now
and continue for 15 years? Well, you’d invest a total of $54,000. At a
hypothetical growth rate of 8%, after 15 years that investment would
be worth $103,811.47 – a difference of $49,811.47!
The lesson: The federal budget deficit could threaten your financial
security in retirement. But planning now and investing monthly can
help you build assets over time, and possibly make up for any future
shortfall in Social Security and Medicare. A financial advisor can help
you learn how to take the right steps to make sure you have the money
you need for a comfortable retirement.
160 ECONOMY
Currency Values
The falling dollar
Many people become worried when the value of the U.S. dollar rises,
but I’m not sure they need to be. Instead, I think they should worry
when the dollar loses value.
Before I explain why, let’s look at what happens when the dollar’s
value rises. For starters, U.S. exports become more expensive. As a
result, American companies are less competitive against their foreign
counterparts. That’s bad news for the American manufacturing sector,
which has struggled since late 2000. Indeed, last month the government
reported that the U.S. deficit in international transactions, mainly trade,
reached an unprecedented $666 billion in 2004, a 24% increase from
2003 levels. That’s 5.7% of the U.S. economy. Many economists believe
it is two to three times higher than it should be.
ECONOMY 161
But the good news is that when the dollar rises in value against other
currencies, imports – such as Italian leather goods and French wines –
are less expensive. That’s because importers and retailers in the United
States buy goods in a foreign currency that is falling relative to the
dollar, so they’re able to pay less to obtain the goods than they did
previously.
Now, the Bush administration expects foreigners, primarily Asian central

bankers, to keep the dollar high by continuing to invest huge sums in
it. As evidence, it cites a recent government report showing that the
United States attracted $91.5 billion in net foreign capital in January,
easily covering that month’s near-record trade deficit of $58.3 billion.
Why would foreign investors buy a depreciating currency? According
to the Bush administration, doing so increases their countries’ exports
– which American consumers buy plenty of very cheaply, as described
above.
While this makes some sense, I disagree with the Bush administration.
Hedge funds – not investment by foreign governments – were
responsible for much of the net foreign capital the United States
attracted in January. And that’s worrisome because hedge funds
often make short-term investments.
I believe that what has attracted foreigners to the U.S. dollar has been
higher interest rates, and that’s a short-term attraction. As long as the
Federal Reserve (Fed) keeps raising interest rates, foreign investors
will keep buying U.S. dollars. But what happens when the Fed stops
raising interest rates, as they eventually must do? The dollar fell recently
when one key member of the Fed just suggested that interest rates
might peak at a lower level than expected. Want evidence of my theory?
When officials from Japan, South Korea, India, and Russia made
comments about diversifying away from U.S. dollars, the financial
markets didn’t like this at all.
162 ECONOMY
So what will happen if the world’s central bankers accumulate fewer

dollars? The dollar will weaken and Americans will need to borrow
more. That could lead to higher interest rates and higher prices, and
ultimately, a lower standard of living. Why? Because the opposite
of what I described above will happen – U.S. exports will be less
expensive and imports will be more expensive, which will be good
for the American manufacturing sector, but not so good for American
consumers. That’s why I think Americans should be more worried
about a falling, not rising, dollar.
ECONOMY 163
The Price of Crude

Oil and your money
Many investors are feeling jittery about higher oil prices, and it’s no
wonder. Most economists agree that 9 of our 10 post-war recessions
began with oil price increases. Could high oil prices cause an economic
slowdown today, you might ask? Should you prepare by adjusting your
portfolio?
Because the economy is dynamic, it’s difficult to draw hard and fast
rules. Even the opinions of economists differ on how much the recent
spike in prices will affect economic growth and whether the current
expansion is at risk. But here’s what we do know.
Oil prices are high. The cost of a barrel of crude oil neared $50 in August,
the first time in more than two decades of government reporting.
Secondly, high oil prices do create an economic headwind, because
when oil prices rise, almost everyone is affected.
164 ECONOMY
If you drive, for example, you’ll pay more for gas. According to the
U.S. Energy Information Agency, a family with two cars that logs
22,000 miles a year, at an average of 20 miles per gallon, will spend an
additional $550 per year if gasoline rises 50 cents a gallon.
Yet even people who don’t drive are affected by high oil process. The
manufacturers from whom you buy the products you use every day,
such as groceries, use fuel to transport those products. A rise in fuel
costs could lead them to raise prices too. When products cost more,
consumers tend to buy less. And when consumers buy less, the whole
economy suffers. In fact, this may already be happening: Consumer
spending started slowing down last spring, and the U.S. Gross
Domestic Product expanded at a slower-than-expected annual pace of
3% in the second quarter, down from 4.5% in the first quarter.
But before you start to panic, consider the positive news. Although
what most consumers see is that the cost of gasoline has jumped
tremendously since it was less than $1 a gallon in the late 1990s, oil
prices are still historically low. Consider that the price of a barrel of
crude, adjusted for today’s dollars, was more than $75 in 1980. Also,
our dependence on oil has decreased. Our factories and homes have
become more energy efficient, and in a service economy like ours,
business is increasingly being conducted over fiber optic cables rather
than roads. Finally, high oil prices don’t always lead to a recession. Four
times during the 1980s and 1990s recessions did not follow spikes in
oil prices, according to the Dallas Federal Reserve.
I think most economists would worry more if we were seeing severe

energy shortages, as we did in the 1970s. If that happens, the odds
of a recession occurring could rise, because when people panic they
become excessively cautious, and their loss of confidence can be much
more devastating than oil price increases alone.
ECONOMY 165
But that’s not happening. Even though oil prices are high, they are
not continuing to climb. In late August, for example, they fell for four
straight trading sessions after Iraq boosted oil exports and fears about
Russian production eased. That was the longest sustained fall since
early February.
So, although any disruption, however minor, may cause prices to spike
again, I’m not worried. And even if I were, I wouldn’t advise you to
change your investments on that basis. Yes, higher oil prices could
cause an economic slowdown, which could be bad for certain elements
of your portfolio. But it could also be good for investments such as
oil company stocks. And regardless, timing the market is seldom a
successful, long-term investing strategy. Instead, I advise you to build
a portfolio that works for the long term, then stick with it.
166 ECONOMY
The Threat of Inflation

Rising interest rates and bonds
While the Federal Reserve (Fed) does not appear to be too concerned
about inflation, the economic policy makers have said that inflation
risks have increased, and therefore interest rates need to be raised. To
many income investors, this opens up an entirely new issue – falling
bond values.
The price of a bond changes throughout its life in response to many

factors, one of which is interest rates. When interest rates go up, bond
prices tend to move in the opposite direction, making existing bonds
less valuable.
Assume you buy a $10,000 bond when interest rates are at 5%. In this
case, your bond yields 5% of $10,000, or $500 annually. Suppose that
after you purchase that bond, interest rates rise to 8%. Now a newly
purchased $10,000 bond yields $800 annually. Your existing bond
pays $300 less a year, so it is less valuable and its price will tend to fall.
ECONOMY 167
When interest rates fall, the opposite is true: Existing bonds become
more valuable. The rise and fall of interest rates not only impacts bonds,
but the share prices of mutual funds that hold bonds.
No one can predict what will happen to interest rates in the near
future, but the Fed has suggested that it will continue raising interest
rates throughout this year and maybe even into 2006. And since higher
interest rates lead to lower bond prices, bond prices can be expected
to fall – except for one thing. Yes, there is an exception. Bond prices
have already fallen in anticipation of the Fed raising rates. So bond
prices will likely only fall more if the Fed raises interest rates higher
than the bond market has anticipated. That’s good news for those of
you who already own bond and bond mutual funds.
Plus, whatever happens, it’s important to remember that price isn’t the
only factor to consider when investing in bonds. When interest rates
rise and bond values fall, higher yields could be available, making it
possible for mutual funds invested in bonds to raise income dividends.
In fact, bond fund managers sometimes take advantage of rising
interest rates by purchasing higher yielding bonds.
If you’re still concerned about the effects of rising interest rates on

bonds, however, you do have some options.
1. Move more of your portfolio into stocks if you can tolerate the
increased risk.
Historically, stocks have had higher returns than any other asset
class, especially bonds. So your best chance for keeping your money
growing ahead of inflation is to move it into stocks. Needless to
say, this will most certainly increase the risk to your principal.
For that reason, make sure you read my previous chapter on the
importance of diversifying your portfolio.
2. Look for bond mutual funds that hold bonds with lower maturities
and average duration.
If interest rates rise, you don’t want to be “locked in” to bonds
that don’t mature for years because they will be worth less than
168 ECONOMY
newly purchased bonds. But if you purchase shares of a fund that

specializes in faster maturing bonds, the portfolio manager will be
able to replace lower price bonds as they mature.
3. Consider municipal bonds.

Municipal bonds – typically debt securities issued by a state or local
government or governmental entity to raise money for building
roads, schools, etc. – tend not to be as affected by interest rates
as are other types of bonds. This may be because a strengthening
economy, which generally accompanies an interest rate hike,
can improve issuers’ financial health and bolster the returns on
municipal bonds.
4. Diversify.
The same old advice remains true: When you have a mix of different
types of investments, such as stocks and bonds, you can better
weather the ups and downs of the market.
It doesn’t hurt to give at least some attention to what’s happening in

the U.S. economy. After all, it’s better to make adjustments to your
retirement portfolio – if they are needed – than to wish you had.
NINE
ESTATE PLANNING CHAPTER 169
Isn’t a Will Enough?

Why you may need a living trust
Many people put off estate planning because they don’t want to think
about their death. But taking the time to plan now – while you are
able to –can make the transition easier for your heirs. It can also make
certain that your assets are distributed according to your wishes.
Relying on a will as your primary estate planning tool can have big
disadvantages. Specifically, before listed assets can be distributed, they
must be processed in state probate court, which can be time-consuming
and expensive, and is open to the public.You may, therefore, find that a
revocable living trust is a better option.
A revocable living trust establishes a legal entity with the power to hold
title to assets. In other words, assets are owned not in your personal
name but in the name of the trust. While that may sound frightening,
in reality it’s a pretty simple legal construct.
170 ESTATE PLANNING
A revocable living trust is created and governed by the terms of a trust

agreement. This agreement lists the assets held in the trust; names a
trustee, who is the individual with the power to manage and distribute
those assets; and states the beneficiaries, or the individuals entitled to
benefit from those assets (such as you and your family).
The assets are still yours. And, depending upon state law, you may be
able to act as trustee and receive income from the trust as a beneficiary
during your lifetime. Then, when you die, or if you become disabled,
the successor trustee named in the agreement will take over the
management and distribution of assets from the trust according to the
terms of the trust. This successor trustee can be a legal advisor or a
friend.
There are several advantages to having a revocable living trust:
1. It avoids the probate process.

As a result, distributions in accordance with the terms of the trust
can occur relatively quickly after your death.
2. Unhappy relatives will find it more difficult and expensive to
challenge the provisions of the trust as they will be forced to bring
litigation against the trustee.
While wills can be contested, if the will is part of a trust, any assets
being passed on through that trust, in accordance with the will,
cannot be contested.
3. The trust will bypass the probate process.
That makes your estate less subject to public scrutiny than a will
would be.

In general, individual retirement accounts (IRAs), annuities, and life
insurance policies do not need to be placed in a trust. The beneficiary
is listed on each of these assets and, based on federal law, they already
bypass probate and their proceeds are turned over directly to the
beneficiaries.Yet there are a few reasons why you may want to consider
placing these three assets in a trust, and only after meeting with a
qualified estate planner should you decide whether to do so.
ESTATE PLANNING 171
Other assets, however, can be probated, and you should carefully weigh
whether or not those assets belong in a trust. Although any assets
owned by a trust pass through it probate-free, revocable living trusts
aren’t for everyone. Establishing one requires the services of an estate
planning professional, since the trust agreement is a legal document
and is governed by state law, which varies from state to state. There can
also be federal and state tax consequences, depending on how the trust
is structured. For example, the assets held in the trust will generally be
included when calculating any applicable federal estate tax.
There are far too many different situations to discuss here. If any of
these subjects are of interest, you should consult an estate planning
attorney to figure out which estate planning structure would best suit
you and your heirs. If you have not thoroughly considered your own
circumstances, or received qualified advice from an estate planning
attorney, you could be doing yourself and your family a tremendous
disservice.
The tax and legal information in this article is merely a summary of my

understanding and interpretation of some of the current laws and regulations and
is not exhaustive. Investors should consult their legal or tax counsel for advice and
information concerning their particular circumstances.
172 ESTATE PLANNING
TEN
LONG-TERM CARE CHAPTER 173
Long-Term Care Insurance

It’s not for everyone
The years following your retirement are supposed to be your
“golden years” – the time of your life when you can enjoy the fruits
of your labor. For some, that may mean finally having the opportunity
to travel or indulge in a hobby. Maybe it’s golf, spending time with
grandchildren, or engaging in some other leisure activity. However
you choose to spend your post-work life, the idea is to relish the fact
that you don’t have to worry about work anymore.
Yet for countless retirees, those golden years can be anything but, due
to illness of one type or another. It may be the consequence of aging, or
the result of years of bad habits. Obviously, medical care then becomes
a primary issue. And even more troublesome is the thought of long-
term care.
There’s no doubt about it: Long-term care insurance is a touchy subject.

Nobody wants to think about a time when they may be ill or disabled.
174 LONG-TERM CARE
But the fact is, many of us will need help when we’re older, and the
costs of such services can be overwhelming. However, planning now
can help you prepare for those financial demands, and that includes
thinking ahead about long-term care.
Long-term care is expensive, and many people underestimate the

cost. Nationally, nursing home care ranges from $137 to $260 a day,
or $50,000 to $95,000 a year, including room and board, drugs, and
medical supplies. In-home health care runs more than $300 a day in
some parts of the country, according to the New York State Partnership
for Long-Term Care and the Connecticut Department of Social Services.
Even worse, the costs of long-term care are expected to triple over the
next 20 years, according to the U.S. General Accounting Office, which
makes planning for care crucial.
Many of us assume that Medicare or Medicaid will cover the expense

of long-term care. In reality, Medicare coverage for long-term care is
limited. It generally covers only about three months of nursing home
care immediately following a hospitalization (and co-pays may apply).
While Medicaid will cover some long-term care costs, to be eligible for
coverage, you must exhaust virtually all of your personal resources. If
you’re single, this may not be worrisome; you’ll have less to leave to
your heirs, but you’ll be cared for. But if you’re married, draining your
joint assets may not leave your spouse with enough money to live on.
The end result is that more than half of nursing home bills are paid
out-of-pocket by individuals. And as you can see by the estimates,
costs can mount up very quickly.
Faced with this prospect, more people are opting to purchase long-
term care insurance to ensure that they’ll be taken care of in their later
years. But how do you decide if long-term care insurance meets your
needs?
Essentially, if you either have substantial assets or very little money,

bypassing long-term care insurance may be the right choice. Although
that may sound crazy, let’s look at the two extremes. If you’re financially
well-off and can set aside enough money for four years of long-term
LONG-TERM CARE 175
care ($150,000 to $200,000, plus allowances for inflation) while still

leaving enough funds to support dependents, you probably don’t need
long-term care insurance. On the other hand, if your annual income is
$30,000 or less and your savings aren’t extensive, you’re likely to qualify
for Medicaid soon after entering a nursing home, so purchasing long-
term care insurance probably wouldn’t make sense for you either.
If you fall somewhere between these two extremes – as most people

do – the United Seniors Health Cooperative, a nonprofit consumer
organization based in Washington, D.C., recommends you consider
long-term care insurance provided you meet four basic criteria:
1. Your annual household income averages at least $30,000 for

every person in your household;
2. You have more than $75,000 in saved assets for each person in
your household, excluding house and car;
3. The cost of the policy is no more than 10% of your annual
income (and preferably closer to 5%); and
4. You could afford the policy if the cost increased by 30%.

(It doesn’t make sense to pay for a policy for years and then
cancel it.)
Of course, deciding to purchase long-term care insurance is just the

first step. Determining at what age it is appropriate to buy a policy
and what kind of policy to buy can also be major challenges. How
much should you pay? Is it tax deductible? Even if you think you know
the answers, it’s best to contact a professional, such as a financial
advisor, who is knowledgeable about the subject and can walk you
through the options that are available to you. He or she can give you
the information you need to help you make a decision most suitable
for your situation.
176 LONG-TERM CARE
Medicaid Eligibility
Even the middle-income may qualify
Many people believe Medicare covers the costs associated with long-
term care. Actually, Medicare usually covers only about three months
of nursing home care immediately following a hospitalization, and
even then co-pays may apply. But you do have other options when it
comes to your long-term care, and they include Medicaid.
Medicaid typically pays for medical care for individuals and families
with low income and few resources, and does cover some long-term
care expenses. However, to be eligible, you have to exhaust most of
your personal resources. The amount of assets that you’re allowed to
keep and still remain eligible for Medicaid benefits differs from state
to state. In general, the person entering the nursing facility may have
no more than $2,000 in “countable” assets. If assets are greater than
$2,000, it is required that the person “spend down” or exhaust their
personal assets until they reach the qualifying level.
LONG-TERM CARE 177
Does this mean that Medicaid is only for the very poor? Not necessarily.
“If I were single”, many people reason, “Medicaid ‘spend-down’
rules wouldn’t be such a concern. Sure, I’d have less to leave to my
heirs, but I’d be cared for. Since I’m married, these rules could create
complications for my spouse. She may not have the same assets or
income to live off of if I enter a nursing home and depend on Medicaid
to finance it.”
Because of this belief – that Medicaid benefits will only kick in once
a recipient’s assets have been drained – many couples purchase long-
term care insurance, which can be expensive. It currently ranges from
about $300 a year if you’re 50 to more than $5,000 a year if you’re over
75. Yet middle-income married couples may, in fact, be able to bypass
long-term care insurance and rely on Medicaid for their long-term care
needs due to spend down exclusions. While the person entering the
nursing facility may have no more than $2,000 in “countable” assets
in 2004, that patient’s spouse (called the community spouse) can keep
half of the couple’s countable joint assets up to $92,760. Some states
are even more generous, allowing the community spouse to keep up
to $92,760 regardless of whether this represents half of the couple’s
assets.
What’s even better news is that not all assets are counted against this
limit. Excluded, for example, is the couple’s primary residence, as long
as the community spouse or another dependent relative lives there.
Even if the community spouse doesn’t live there, the nursing home
patient may be able to keep his or her home. In some states, the
home will not be considered a countable asset for Medicaid eligibility
purposes as long as the nursing home resident intends to return home.
In other states, the nursing home resident must prove a likelihood of
returning there.
Other assets excluded from Medicaid spend down rules are one motor
vehicle of any value; personal possessions, such as clothing, furniture,
and jewelry; prepaid funeral plans and a small amount of life insurance;
and other assets that are considered “inaccessible” for one reason or
another. Finally, in all circumstances, the income of the community
178 LONG-TERM CARE
spouse may continue undisturbed. The community spouse does not

have to use his or her income to support the nursing home spouse
receiving Medicaid benefits.
What does this mean for you? Well, let’s say you and your spouse
have a home worth $400,000, a car worth $20,000, and savings and
investment accounts worth $200,000. If you enter a nursing home, your
spouse would be able to keep the house and the car. Before Medicaid
kicked in to pay for your care, you’d have to spend down your savings
and investments to $92,760, but that would be your spouse’s to keep.
Your spouse would also be able to keep any income he or she earned.
Of course, this is only the tip of the iceberg. An excellent online

resource for more information, with a state-by-state guide, is Elder
Law Answers at www.elderlawanswers.com (the source for all Medicare
and Medicaid information). And you can always consult a financial
advisor for assistance.
I frequently get questions about how to protect assets against the

Medicaid “spend-down”. While there are many ways to protect
assets, this is a highly complex subject that is beyond the scope of
this section. It can be done, and if you are interested in getting more
details, I advise you to speak to a qualified Medicaid planning attorney
to discuss your own personal situation.
LONG-TERM CARE 179
Medicare Prescription Drug Plans

Compare before you decide

Beginning January 1, 2006, everyone with Medicare will have access to

a prescription drug coverage program. While that’s welcome news for
many retirees, it’s also causing a great deal of confusion. Many people
are just not sure of what they’re supposed to do. So if you’re a retiree,
here’s what you need to know.
You may not need prescription drug coverage from Medicare. Right
now, retirees receive Medicare coverage in a number of different ways.
How you happen to receive yours will determine the usefulness of
the new Medicare prescription drug coverage. For example, if you
have the original Medicare, as well as a Medigap supplemental policy
with drug coverage, the new Medicare drug coverage will probably
provide much more comprehensive coverage at a lower cost. However,
if you have a Medicare Advantage Plan through a Health Maintenance
Organization (HMO) or Preferred Provider Organization (PPO) which
already includes drug coverage, the new Medicare drug plan may not
offer any further benefit.
180 LONG-TERM CARE
Do your homework. Information is readily available, and before you

make any decision you should compare coverage. If you qualify for
Medicare, you’ve probably already received the Medicare & You 2006
Handbook from the government. Another good reference is a brochure
called What Medicare Prescription Drug Coverage Means to You: A Guide
to Getting Started. If you want to compare specific plan details based on
what matters to you most, you can get personalized information from
the Medicare Prescription Drug Plan Finder. And, to find out how
much you can save with Medicare prescription drug coverage, visit the
Medicare Prescription Drug Plan Cost Estimator. All of these resources
are available at www.medicare.gov, or by calling 1-800-MEDICARE. The
phone line is staffed 24 hours a day, seven days a week.
You have choices. If you decide that you want to take advantage of
the new Medicare drug coverage plan, there are two ways you can do
so. First, you can add drug coverage to traditional Medicare through
a “standalone” prescription drug plan. Or, you can get Medicare and
drug coverage together through a Medicare Advantage Plan. To help
you find Medicare plans by state, the Centers for Medicare & Medicaid
Services created an online resource: See “Landscape of Plans” at www.
medicare.gov.
Know that you may qualify for extra help. Individuals who have limited
income and resources (less than $11,500 for individuals or $23,000 for
married couples) but don’t have Medicaid may be eligible to have about
95% of their drug costs paid. Find out if you meet those qualifications
by visiting www.medicare.gov/medicarereform/help.asp.
There are a number of ways to enroll. You can enroll in a new

Medicare prescription drug plan beginning on November 15. That’s
when Medicare will have an online enrollment center available at
www.medicare.gov. You can also enroll by calling any plan’s toll-free
number, by mailing an application in to the plan, or by visiting the
plan’s Web site. If you want your coverage to start on January 1, 2006
you must sign up by December 31, 2005.You can enroll in a plan as late
as May 15, 2006, however if you do so, you won’t receive coverage for
the entire year.
ELEVEN
GIFTING CHAPTER 181
The Gift of a Lifetime

Savings accounts for kids
For many people, being a grandparent presents an opportunity to share

accumulated wealth with a grandchild. But have you considered giving
a gift that can last the child a lifetime? Or encouraging your teenage
grandchild to do the same? Consider the following options.
Individual retirement accounts (IRAs)

For many teenagers, summer offers a chance to earn some extra cash.
But earning money also means your teenage grandchild is eligible to
open an individual retirement account (IRA). The teenage years may
seem early to start investing, but it can make a big difference.
Let’s say 16-year-old Marie earns $4,500 from her summer job at the
mall. Since she has earned income, she can deposit up to $4,000 in a
Roth IRA. If that money is left untouched until Marie retires at age
182 GIFTING
66, and the investment grows at a hypothetical rate of 8% each year,

Marie could accumulate more than $130,000 – money that could be
distributed tax-free.
UGMA/UTMA Account
Even if your teenage grandchild doesn’t have earned income and thus
can’t contribute to an IRA, he or she is eligible for another type of long-
term savings plan: A Uniform Gift to Minors Act (UGMA) account or
Uniform Transfer to Minors Act (UTMA) account. As a grandparent,
you can open a UGMA or UTMA account in a grandchild’s name and
designate yourself, the child’s parent, or even a friend to administer
the account until the child reaches the age of majority.
You can contribute as much as you want to the account, but the first
$12,000 given, per person, counts toward the annual gift tax exclusion.
So, if your spouse consents and you file IRS Form 709 (or, if applicable,
form 709-A), you and your spouse may “gift” up to $24,000 per year
tax-free.
Coverdell ESA
A Coverdell Education Savings Account (ESA) is an investment tool
specifically designed to pay for a child’s education. Almost anyone
may contribute – including relatives and friends – up to $2,000 per
year (assuming the person has a modified adjusted gross income
below certain limits). A child can receive a combined total of $2,000
per year from all contributors. Contributions aren’t tax-deductible,
but qualified distributions are tax-free, which means that investment
earnings won’t be taxed.
The greatest benefit of the Coverdell ESA is that the money can be used
be used for any qualified expenses. That may be tuition for private or
parochial schools, or the cost of state-approved home schooling from
kindergarten through 12th grade, as well as college. Other qualified
expenses include academic tutoring, student uniforms, extended day
care programs, Internet access, and computer equipment. If the assets
aren’t used by the time the child reaches age 30, the child has two
GIFTING 183
options: He or she can roll the assets over to another family member’s
Coverdell ESA or the assets can be withdrawn, but in this case
investment earnings will be taxable as income and subject to a 10%
penalty.
Finally, remember that starting early can pay off. If you had opened a
UGMA or UTMA account when your grandchild was born in December
1975 and put a little more than $3 a day ($100 a month) in the Standard
& Poor’s 500 Index (say, through an index fund) until he or she turned
18 in December 1993, that account would have grown to $65,443,
thanks to an average annual return of 9.45%. If your grandchild got
a scholarship and didn’t touch the money, by the end of 2004, that
account would have exceeded $150,000.
Maybe you didn’t have $3 a day to invest for your child when he or she
was growing up. Maybe you didn’t think so little would grow enough
to make that much of a difference. So why not invest that $3 now, or
whatever amount you can, for your grandchild?
184
TWELVE
EDUCATION CHAPTER 185
Not for School Only

529 plans for retirees
Your children are grown and you’re well past the thought of college
expenses. But you may be surprised to learn that 529 plans aren’t just
for couples with college-aged children. They’re for retirees too, thanks
to a regulatory loophole that allows them be used to shelter millions of
dollars from estate taxes. Could you possibly benefit?
First, let’s go over how 529 plans were intended to work. Initially, they
were designed to help people save money on a tax-deferred basis
for their children’s, grandchildren’s, or their own college education.
You open an account, contribute, and the account operates like a tax-
deferred investment portfolio. You retain full control of the account’s
expenditures and you can switch the beneficiary designation to
another member of the beneficiary’s family at any time. You can also
withdraw money from the account at any time by paying income tax
on the earnings as well as a 10% penalty.
186 EDUCATION
So why would retirees be interested in these plans? Well, as you

probably know, a person can normally give another individual $12,000
per year without tax consequences through what’s called a gift tax
exemption. And 529 plans allow people to use five years of this gift
tax exemption at one time. So you and your spouse could contribute
$120,000 to a single 529 plan account at once. That would certainly
reduce your estate taxes!
To illustrate how that could happen, let’s assume you have three
children and six grandchildren. You set up 529 plan accounts for all of
them. At $120,000 for each beneficiary, that’s more than $1,000,000 in
assets you could transfer at once (nine descendants x $120,000). And
that’s $1,080,000 that is removed from your taxable estate.
But there’s another way you can use 529 plans as a retiree – for yourself.
Say you want to save money, tax-deferred, for use later in your life.
You can designate yourself as the beneficiary of a 529 plan account.
You save money for a number of years, then when you’re ready, you
go back to school part-time. The money in the 529 plan can be used
to help pay not just for your education expenses, such as tuition and
books, but for certain living expenses like an apartment.
Yes, this is completely legal. It can all be found under U.S. Code Title
26 (Internal Revenue Code), Subtitle A, Chapter 1, Subchapter F,
Part VIII, Section 529. For more information, check out the Internal
Revenue Service Web site at www.irs.gov and search the above
mentioned section.
Of course, there are some caveats. Specifically, the improper use of

529 plans can trigger taxes and penalties. For example, if you group
five years of gifts into one year and you die before the five-year period
is up, only a prorated portion of the gift will stay out of your estate.
Or, if a beneficiary designation is changed to someone in a younger
generation, the original beneficiary may have to pay taxes.
Additionally, no one knows what will happen with 529 plan rules
in the future. The law governing 529 plans – the Economic Growth
EDUCATION 187
and Tax Relief Reconciliation Act of 2001 – expires at the end of 2010.
Unless the law is extended by Congress and the president, the federal
tax treatment of 529 plans will revert to their status prior to January 1,
2002 – distributions for qualified educational expenses are taxable to
the recipient.
In summary, 529 plans provide plenty of financial flexibility, so you

may want to find out how you can make use of them to accomplish
financial and tax objectives for yourself or your family. But be sure
to talk to a financial advisor who knows how 529 plans work before
attempting to implement any of the strategies discussed in this column
as it can get tricky.
The tax and legal information in this article is merely a summary of my

understanding and interpretation of some of the current laws and regulations and
is not exhaustive. Investors should consult their legal or tax counsel for advice and
information concerning their particular circumstances.
188
THIRTEEN
THE TEN CHAPTER 189
COMMANDMENTS
OF INVESTING
While wrapping up this book, I felt compelled to provide a very brief

summary of what I would call my “10 Commandments of Investing.”
Consider this my extremely abbreviated summary of the things you
should never forget when investing and planning your future. Please
be advised: These commandments are not listed in any order of
priority, so don’t think of “number one” as being the most important.
At some level, they are all very important. On your journey to and
through retirement, if you remember only one chapter of this book, try
your best to remember this one.
Drum roll, please. Here they are, my “10 Commandments of

Investing“:
1. Stick with the indexes.

Leave the individual stock picking to gamblers and speculators.
Very few people really understand how to successfully pick
individual stocks, and if they do, the news that drives markets
today is totally unpredictable, making individual stock picking a
highly risky venture. Reams and reams of statistics prove index
investing almost always outperforms the financial advisors, money
190 THE TEN COMMANDMENTS OF INVESTING
managers, and stockbrokers. Stick with the indexes and you’ll

likely wind up far ahead of the game.
2. Watch those fees.

Wall Street loves investors that don’t watch their fees. For those
investing in funds, check out www.personalfund.com. You might
be shocked to find out the total cost your funds are charging you
to own them year after year. Especially over the long haul, fees
can destroy your returns. Minimize fees as much as possible by
investing in low-fee, highly diversified investments such as one of
my personal favorites, Exchange-traded Funds.
3. Create a bond ladder.

For income, bond funds are the favorites among many advisors.
They’re simple, quick, and unfortunately, usually loaded with fees.
Consider laddering bonds instead. Why? Mutual funds consisting
of bonds have no maturity dates. If the value of the fund goes
down, good luck trying to guess when your principal will “come
back.” With a laddered bond portfolio, as long as the bonds don’t
default, you have a date when your money will be returned to you.
Creating a bond ladder is not as easy as choosing a few bonds
funds; it usually requires the assistance of a skilled advisor. But the
next time an advisor recommends bond funds for income, be sure
to strongly suggest this as an alternative. However, many advisors
don’t know how to construct a ladder, and if they have little or no
experience doing so, I would suggest finding someone else to be
your advisor.
4. Diversify.
You’ve heard it a thousand times, but it’s amazing how few people
actually do it. Diversification saves lives and prevents disasters,
especially when you don’t ever put too much money in one place.
Also be certain to understand the concept of “rebalancing.”That’s
important stuff, and if you don’t understand it, go back and read
that section in this book to make sure you do. Rebalancing, together
with diversification, will likely one day save your investment life.
THE TEN COMMANDMENTS OF I N V E S T I N G 191
5. Watch your money.

No one else will ever keep track of your money like you will. Don’t
get lazy and stop paying attention. Read your statements every
month and monitor your progress and returns. This is your life
we’re talking about, and don’t ever forget that.
6. Don’t rush in.

You’ve likely heard the saying “only fools rush in”. On every level,
rushing into things can cause great harm. Whether it’s rushing in
to get high returns, rushing out as a result of emotion, or rushing
into a decision as to where to invest, first pause, take a deep
breath, sleep on it, and then make your decision. As a “subset” of
this commandment, I would also include: Be careful when listening
to others. What’s good for one person is terrible for another. The
media does a great job of generalizing advice and investments, and
I think that’s an awfully dangerous game to play. Unless someone
really understands your personal situation and goals, I firmly believe
it’s nearly impossible to make conclusive statements about “what’s
good” and “what’s bad.” No good doctor could ever diagnose a
problem without getting the answers to some basic questions. If
they fail to do this, prescribing a pill can literally kill you. The same
is true with investing. Only when a few key questions are answered
could anyone really give prudent advice on“what’s good”or“what’s
bad”for you. So the next time someone tells you to“stay away from
__________,”or “you should invest in_________,”be very cautious.
Educate yourself, assess the advantages and disadvantages of the
advice you’re getting, pause, then make your decision.
7. Don’t take the risk if you don’t need the return.

Many people would do perfectly fine getting 7-10% returns on
their money, yet their portfolios are invested in things that strive
for well beyond that. Especially if you’re a retiree, if you doubled or
tripled your money overnight, would you go out and buy a fancy
new sports car? A mansion on the water? Few of us would. And
for that reason, always ebb towards the safer side of investing as
much as you possible can.
192 THE TEN COMMANDMENTS OF INVESTING
8. Get out if something isn’t working.

The greatest investors I’ve ever known are the ones who don’t get
emotional about their money. I’m not talking about the Warren
Buffets of the world. I’m talking about highly successful investors
I’ve met who were schoolteachers, electricians, and small business
owners. Some of the best investors I’ve met are those who
understand that becoming emotional about an investment often
leads to disasters. Easier said than done, I know, but this one is
very important: Don’t ever fall in love with an investment. If it isn’t
working, cut it off before you really regret it.
9. Understand tax consequences.

I’d place this right alongside number two above. Over time, the tax
ramifications of your investments can really help or hurt you. It’s
been said that “It’s not what you earn, it’s what you keep.” Amen.
You absolutely, positively need to understand the basics of what
happens with your taxes when you move money, especially if
you are investing in mutual funds that often create taxable events
beyond your control.
10. Keep it simple.

Only one more commandment? That’s too bad. I can think of
many more favorites – start as early as possible, take advantage
of compounding, max out your qualified plans, etc. But if I had to
pick only one more point to complete this list, it would have to be
keep it simple. I once met a very successful investor who did quite
well for himself over many years. His entire portfolio consisted
of literally three positions: a Standard & Poor’s (S&P) 500 index
fund, a low-cost bond fund and a low-cost international stock
fund. Other than some cash sitting on the sidelines, that’s it, and
not surprisingly, he did better than most investors I’ve met with
phone books of investments to keep track of. While I certainly
don’t endorse keeping your entire portfolio in three positions, I
can say that keeping it simple is a universal lesson of life itself, and
in the world of investing, it allows you to do one very important
thing: keep track of what you have and how it’s doing. The more
complicated things get, the more room there is for disaster. It really
is as simple as that.
193
Conclusion
Have you learned anything new? Do you have a better idea of how
your retirement vehicle operates? Have you become more familiar
with its parts?
Upon beginning your journey through this book, you were asked
whether you thought you were prepared for retirement. Now that
you’ve had a chance to review the chapters on various topics – the
operating manual for your retirement vehicle – do you feel the same
way?
If you thought you were prepared for retirement and you still feel you
are, congratulations, you are in the minority. But if not, if you realize
there are issues that need your attention, or you knew you weren’t
prepared, I hope this book has been of some help. I would like to think
the information presented here has at least shed some light on the
long highway of retirement, put you on the right road, and helped
ensure you are headed in the right direction.
And now that you have some idea of what to look for, have you assessed
the condition of your retirement vehicle? Is it in good shape? Are its
systems operating correctly? Do any parts need to be replaced?
Only you can determine your destination, but the right financial advice
can make it easier for you to get there. A qualified financial advisor can
help you plan your route, after you’ve had a chance to get to know one
another and thoroughly discuss your personal financial situation.
194 CONCLUSION
Remember, reaching retirement may signal the end of one trip, but
it also marks the beginning of a marvelous new adventure. So try to
maintain a full tank of gas if you can, keep an eye on the road, and
monitor the gauges. Stay on the lookout for accidents, roadblocks, and
detours – anything that can get in the way of you moving forward. And
be prepared to take an alternate route if you need to.
Most of all, don’t be afraid to stop and ask for directions. The financial
world has become quite complicated and very overwhelming, but the
ride through your retirement doesn’t have to be. With so many good
ideas and products to choose from, you can’t be expected to learn
everything. And there are so many parts to a retirement vehicle that it’s
easy to overlook some of them. That’s where asking someone who has
the expertise to help you get your vehicle in the best possible condition
to navigate smoothly through retirement can be invaluable.
Finally, don’t be afraid to open up your “manual” once in a while

as a refresher. After all, you’re not a mechanic, you’re not required to
remember the details of how each part of your vehicle operates, and
frankly, that’s what manuals such as these are for.
As you plan, begin, or continue along your retirement road trip, I want
to wish you and your family a very safe and pleasant journey ahead.
For more information, visit www.alanhaft.com.

196
For more information, visit

alanhaft.com
198
200

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All rights reserved. No portion of this publication may be reproduced or

Published in Boca Raton, Florida, by TriMark Press, Inc.

Printed and bound in the United States of America.

About the Author

Chapter 1: Retirement Planning

Chapter 2: Investing (continued)

Chapter 9: Estate Planning

Chapter 10: Long-Term Care

Chapter 11: Gifting

Chapter 12: Education

Chapter 13: The 10 Commandments of Investing

ABOUT THE AUTHOR

Alan Haft is a nationally recognized investment advisor who has been

His financial column“The Haft of It”appears in a variety of newspapers

With his partners, he has conducted hundreds of financial planning

For more information, please visit www.alanhaft.com

As a financial advisor, I find many of the questions investors ask

These concerns kept arising during many conversations with clients

So that’s what I did. I wrote a few answers to the “frequently asked

*Note to readers: Everyone’s personal situation is uniquely different. Investments,

Your financial future is really no different. Your first step is to at least

Many of my clients are retirees or they’re near retirement. When they’ve

Most importantly, your vehicle must be prepared for retirement, since

Wouldn’t it be helpful if you had a manual of some kind so you could

retirement vehicle or at least information covering some of its “basic”

So from me to you, here’s hoping that your retirement vehicle will be

Five Common Investment Mistakes

Starting sooner is always better. It requires you to set aside fewer

1. Thinking it’s too late to start planning.

2. Underestimating your life expectancy.

3. Not calculating your savings needs.

4. Not taking inflation into account.

5. Putting other financial goals first.

Considering a Financial Advisor?

So how do you know if the person you’re considering is really qualified?

2. Is this person really a financial advisor?

3. What licenses does the financial advisor hold?

How do you know if someone only has an insurance license and

To make it simple, follow this simple rule of thumb: If there is no

4. Have you checked out the financial advisor’s background?

5. Has the financial advisor explained risks and rewards?

6. How is the financial advisor paid?

Generalizing which type of fee arrangement you should consider is

CFA – Chartered Financial Analyst

ChFC – Chartered Financial Consultant

CPA – Certified Public Accountant

PFS – Personal Financial Specialist

RIA – Registered Investment Advisor

Interviewing Your Next Financial Planner

Before deciding on a financial planner, you’ll want to interview several,

These two topics are more difficult to discuss because financial

When hiring a financial planner, then, it’s important to know in

On the other hand, if you already have a number of investments with

Finally, you’ll want to listen to how each financial planner answers

making any recommendations? Does he or she clearly express that

Custodial Accounts and Trusts

These accounts are well-suited to relatively small dollar amounts

Employer-Sponsored Retirement Plans

Employer-sponsored retirement plans are a great way to save for

Whenever I encounter people in this situation, I often suggest that

1. A rollover IRA may provide better investment options.

On the flip side of this, every once in a while I meet a person