Wild Ride or Quiet Stroll?

The stock market has taken investors on a wild ride for the past several years. For example, a hypothetical portfolio of stocks mirroring the S&P 500 would have taken until 2006 to recoup losses sustained during the three-year bear market that began in 2000.¹

Meanwhile, an investment in low-risk 10-year Treasury bonds wouldn’t have lost a penny during the same time period — or at any time during the past 25 years (see table).

Looking back, it might seem as though the portfolio of Treasurys would have been the better investment. But there’s more to the picture.

Dig Deeper
As you can see from the table, the return from stocks was more than four times greater than from Treasurys — in other words, the opportunity cost of playing it safe was almost $175,000. Of course, remember that past performance is no guarantee of future results.

Risk — In this case, the return from stocks was worth the risk, but only for someone who had time to recover from losses sustained during the period. Your own risk tolerance is determined in large part by your time horizon and investment objectives.

Treasury bonds are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. The principal value will fluctuate with changes in market conditions. If not held to maturity, Treasurys may be worth more or less than their original value.

Inflation — Inflation for the 25-year period averaged slightly more than 3% per year.² That’s almost half the average annual return from the bond investment but less than one-fourth of the return from stocks.

It’s impossible to forecast whether stock market volatility will continue, but it would be prudent to assume it will. However, the cost of playing it safe may be higher than you are willing to bear.

1) Thomson Financial, 2007, for the period 12/31/1981 to 12/31/2006. The S&P 500 is generally considered representative of U.S. stocks. The performance of an unmanaged index is not indicative of the performance of any particular investment. Individuals cannot invest directly in an index.
2) Thomson Financial, 2007. Consumer Price Index for the period 12/31/1981 to 12/31/2006.

Prepare to Convert

In the past, only people with adjusted gross incomes of $100,000 or less were eligible to convert their traditional IRAs to Roth IRAs. The Pension Protection Act of 2006 repealed this rule, but it doesn’t take effect until 2010.

In another change starting in 2008, investors can make a direct rollover from an employer-sponsored retirement plan to a Roth IRA, treating it as a Roth conversion (income limits still apply until 2010). Fortunately, you have some time to decide whether a Roth IRA conversion would be an appropriate move for you.

Probably the most popular reason for converting to a Roth IRA is the opportunity to receive tax-free withdrawals in retirement. Another benefit of a Roth is that there are no mandatory distributions during your lifetime.

Although a tax-free retirement income might sound too good to pass up, there are some trade-offs and drawbacks when ­converting a tax-deferred retirement account to a Roth IRA. Here are some factors to consider.

Disappearing Deductions
A Roth conversion may make sense if you expect to be in a higher tax bracket in retirement, or if you expect tax rates to be higher in the future.

Consider this: By the time you are ready to retire, you may have little or no mortgage interest to deduct from your taxes. Your children will likely be grown and no longer your dependents for tax purposes. And you may not be making tax-deductible retirement plan ­contributions.

Taxes Today
A Roth conversion requires that you pay income taxes that have been deferred on qualified retirement plan assets. You can convert the funds all at once or over multiple years. The amount you convert in a given year is included in your gross income when you calculate your taxes. One drawback is that if you use funds from the original retirement account to pay the taxes before you reach age 59½, it would be considered an early distribution and would be subject to a 10% federal income tax penalty.

Of course, to qualify for a tax-free and penalty-free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59½ or due to death, disability, or a first-time home purchase (up to a $10,000 lifetime maximum).

Tax-Free Possibilities

This time of year, “tax-free” probably sounds as good to a taxpayer as ice water sounds to a hiker lost in the desert. Research shows that 59% of people believe their taxes are too high.¹

In our society, just about any financial transaction has tax consequences. But you might be surprised at the potential tax benefits associated with owning life insurance.

Term Policies
An individual term life insurance policy remains in force for a specific period of time and pays a death benefit only if the insured dies during the term. A term policy cannot accumulate cash value and has no residual value if it is allowed to lapse. Although you typically pay the premiums with after-tax money, even this most basic of ­policies offers tax benefits.

* The death benefit paid to the beneficiary upon the death of the insured is not considered income and thus is not taxable.
* If the insured person does not own the policy, the death benefit is not considered part of the individual’s estate for the purpose of calculating estate taxes.
* The death benefit can be used to help pay any estate taxes due on the estate.

Permanent Policies
A permanent life insurance ­policy offers a death benefit upon the insured’s death, but it also has the potential to accumulate cash value during the insured’s lifetime. In addition to the tax benefits already mentioned, permanent insurance has other potentially favorable tax consequences.

* Any premiums paid into the policy that are later withdrawn are not subject to income tax.
* Once all premiums have been withdrawn, the insured may be able to take loans against the policy’s cash value. Because the money is borrowed, it is not taxable as income. Be aware that loans from a life insurance policy will reduce the policy’s death benefit.

The cost and availability of life insurance depend on factors such as age, health, and the type and amount of insurance purchased. Before implementing a strategy involving life insurance, it would be prudent to make sure that you are insurable.

As with most financial decisions, there are expenses associated with the purchase of life insurance. Policies commonly have mortality and expense charges. In addition, if a policy is surrendered prematurely, there may be surrender charges and income tax implications. Before you take any specific action, be sure to consult with your tax professional.

1) Tax Foundation, 2006

An Automatic Strategy to Reduce Turnover

Turnover can be a problem for any business. Its true cost goes well beyond the loss of productivity. Hiring and training costs as well as lost business should also be factored in. According to some estimates, the business cost to replace a key employee or top producer could reach as high as four times the employee’s salary.¹

Providing attractive employee benefits is one way to reduce employee turnover. A defined-contribution plan, such as a 401(k) plan or a simplified employee pension plan (SEP), can result in productive and loyal employees as well as tax benefits for the employer. Furthermore, automatic retirement plan enrollment can help an employer benefit even more from a defined-contribution plan.

New Benefits from Pension Law Changes
Thanks to the Pension Protection Act of 2006, which takes effect this year, there are more incentives for employers to enroll employees automatically in defined-contribution plans. In addition to encouraging automatic enrollment, the law offers “safe harbor” provisions that limit an employer’s liability in offering retirement plans.

Businesses that offer matching contributions to employees’ 401(k) plans could realize tax deductions of 15% to 40% on their own contributions, depending on how much the companies earn.²

Automatic enrollment also offers perks to owners and other highly compensated employees whose contributions may be limited because they are tied to the participation rates of other employees. Automatic enrollment can help alleviate this problem because more workers will participate in the plan — participation rates could grow to 90% — which may result in higher contribution limits for highly compensated individuals.³

Studies have shown that a majority of Americans favor automatic enrollment in retirement plans. In one study, 69% of employed workers favored automatic enrollment, 65% supported automatic increases in the annual contribution percentage coinciding with increases in pay, and 59% favored automatic investing of employee contributions.4

In the past, employers were reluctant to offer automatic enrollment because of state payroll-withholding laws. Fortunately, the pension law offers employers protection when they enroll employees automatically, and employees generally can opt out within 90 days. The law allows employers to increase a participating employee’s contribution level by 1% annually, up to a maximum contribution level of 10%.

Retaining valued employees is a challenge for any business. Offering a retirement plan with automatic enrollment might be one way to help business owners reduce turnover and enjoy additional retirement benefits themselves, and it can lead to a happier work environment.

Contributions to qualified retirement plans, plus any earnings and matching funds, are not taxed until withdrawn. Generally, withdrawals are taxed as ordinary income and may be subject to a 10% federal income tax penalty if distributed prior to age 59½.

1) WebProNews, July 2006
2) Forbes, September 1, 2006
3) MSNBC.com, August 24, 2006
4) 2006 Retirement Confidence Survey, Employee Benefit Research Institute

Don’t Leave “Success” Out of Succession

One in five family business participants has not addressed any estate conservation issues beyond writing a will.¹

Business continuation is difficult enough under normal circumstances, but if it has to take place ­following the unexpected death of a key person or owner, the complications can increase exponentially.

Company-owned life insurance is one way to help protect a business from financial problems caused by the unexpected death of a key employee, partner, or co-owner. If the covered individual dies, the proceeds from this type of insurance can help in several ways. Here are some examples.

Fund a Buy-Sell Agreement
A buy-sell agreement typically specifies in advance what will happen if an owner or a key person leaves the company, either through a personal decision or because of death or disa­bility. The death benefit from a company-owned life insurance policy can be used to purchase the decedent’s interest in the company from his or her heirs.

Keep the Business Going
If a decision is made to continue the business, there may be a period when operations cease while the survivors develop a plan to move forward. The death benefit can be used to help replace lost revenue or to pay costs associated with keeping the doors open, including rent, utilities, lease payments, and payroll. It may also help the surviving owners avoid borrowing money or selling assets.

Replace Lost Income
If a business owner has family members who depend on the income from a business, which simply could not continue if he or she were suddenly gone, the proceeds from company-owned life insurance could help replace the lost income and help protect the family’s quality of life while they adjust and move on.

The appropriate coverage amount will depend on several factors. It could be a multiple of the business owner’s annual salary or the company’s oper­ating budget. Don’t forget to factor in such details as the cost of hiring and training a successor, where applicable, and any debts that the family may have to repay.

A thorough examination of a business and the related personnel should be conducted before the exact amount of coverage is determined.

Remember that the cost and availability of life insurance depend on factors such as age, health, and the type and amount of insurance purchased. Before implementing a strategy involving life insurance, it would be prudent to make sure that the individual is insurable.

The loss of an owner can be devastating to a small business. A company-owned life insurance policy may help reduce the financial consequences if such a loss were to occur.

1) Family Firm Institute, 2005