Understanding the 401(k) Plan

A Shaky Economy: Should You Invest Now?

Should You Borrow from Your 401k?

If you have a 401(k) plan at work and need some cash, you might be tempted to borrow or withdraw money from it. But keep in mind that the purpose of a 401(k) is to save for retirement. Take money out of it now, and you’ll risk reducing the amount of money available during your Golden Years.

Additionally, you will most likely face stiff tax consequences and penalties for withdrawing money before age 59½. Still, if you’re facing a financial emergency–for instance, your child’s college tuition is almost due and your 401(k) is your only source of available funds–borrowing or withdrawing money from a 401(k) may be your only viable option.

Plan Loans
To find out if you’re allowed to borrow from your 401(k) plan and under what circumstances, check with your plan’s administrator or read your summary plan description. Many employers allow 401(k) loans only in cases of financial hardship, but you may be able to borrow money to buy a car, to improve your home, or to use for other purposes. Generally, obtaining a 401(k) loan is easy–there’s little paperwork, and there’s no credit check. The fees are limited too–you may be charged a small processing fee, but that’s generally it.

How Much Can You Borrow?
No matter how much you have in your 401(k) plan, you probably won’t be able to borrow the entire sum. Generally, you can borrow the lesser of $50,000 or one-half of your vested plan benefits. (An exception applies if your account value is less than $20,000; in this case, you may be able to borrow up to $10,000, even if this is your entire balance.)

What are the Requirements for Repaying the Loan?
Typically, you have to repay money you’ve borrowed from your 401(k) within five years by making regular payments of principal and interest at least quarterly, often through payroll deduction. However, if you use the funds to purchase a primary residence, you may have a much longer period of time to repay the loan.

Make sure you follow to the letter the repayment requirements for your loan. If you don’t repay the loan as required, the money you borrowed will be considered a taxable distribution. If you’re under age 59½, you’ll owe a 10 percent federal penalty tax, as well as regular income tax on the outstanding loan balance.

Disadvantages of borrowing money from your 401(k)
If you don’t repay your plan loan when required, it will generally be treated as a taxable distribution.

• You lose the pre-tax advantage of the 401(k) account
• Loan repayments are made with after-tax dollars
• If you leave your employer’s service (whether voluntarily or not) and still have an outstanding balance on a plan loan, you’ll usually be required to repay the loan in full within 60 days. Otherwise, the outstanding balance will be treated as a taxable distribution, and you’ll owe a 10 percent penalty tax in addition to regular income taxes if you’re under age 59½.
• Loan interest is generally not tax deductible (unless the loan is secured by your principal residence).
• You’ll lose out on any tax-deferred interest that may have accrued on the borrowed funds had they remained in your 401(k).

Hardship Withdrawals
Your 401(k) plan may have a provision that allows you to withdraw money from the plan while you’re still employed if you can demonstrate “heavy and immediate” financial need and you have no other resources you can use to meet that need (e.g., you can’t borrow from a commercial lender or from a retirement account and you have no other available savings). It’s up to your employer to determine which financial needs qualify. Many employers allow hardship withdrawals only for the following reasons:

• To pay the medical expenses of you, your spouse, your children, your other dependents, or your plan beneficiary
• To pay the burial or funeral expenses of your parent, your spouse, your children, your other dependents, or your plan beneficiary
• To pay a maximum of 12 months worth of tuition and related educational expenses for post-secondary education for you, your spouse, your children, your other dependents, or your plan beneficiary
• To pay costs related to the purchase of your principal residence
• To make payments to prevent eviction from or foreclosure on your principal residence
• To pay expenses for the repair of damage to your principal residence after certain casualty losses

Note: You may also be allowed to withdraw funds to pay income tax and/or penalties on the hardship withdrawal itself, if these are due.

Your employer will generally require that you submit your request for a hardship withdrawal in writing.

How Much Can You Withdraw?
Generally, you can’t withdraw more than the total amount you’ve contributed to the plan, minus the amount of any previous hardship withdrawals you’ve made. In some cases, though, you may be able to withdraw the earnings on contributions you’ve made. Check with your plan administrator for more information on the rules that apply to withdrawals from your 401(k) plan.

What are the Advantages of Withdrawing Money from Your 401(k) in Cases of Hardship?
The option to take a hardship withdrawal can come in very handy if you really need money and you have no other assets to draw on, and your plan does not allow loans (or if you can’t afford to make loan payments).
What are the disadvantages of withdrawing money from your 401(k) in cases of hardship?

• Taking a hardship withdrawal will reduce the size of your retirement nest egg, and the funds you withdraw will no longer grow tax deferred.
• Hardship withdrawals are generally subject to federal (and possibly state) income tax. A 10 percent federal penalty tax may also apply if you’re under age 59½.
• You may not be able to contribute to your 401(k) plan for six months following a hardship distribution.

What Else do I Need to Know?
If your employer makes contributions to your 401(k) plan (for example, matching contributions) you may be able to withdraw those dollars once you become vested (that is, once you own your employer’s contributions). Check with your plan administrator for your plan’s withdrawal rules.

• If you were impacted by Hurricanes Katrina, Rita, or Wilma, or if you are a reservist called to active duty after September 11, 2001 and before December 31, 2007, special rules may apply to you.

Hedge Funds: An Introduction

With all the media buzz about private equity, clients ask us more than ever about lesser known, riskier investment options. At some point, “hedge funds” usually enter the discussion. In response, here’s our quick analysis of this emerging investment option.

What is a Hedge Fund?
Hedge funds are private investment vehicles that manage money for institutions and wealthy individuals. They generally are organized as limited partnerships, with the fund managers as general partners and the investors as limited partners. The general partner may receive a percentage of the assets, additional fees based on performance, or both.

Hedge funds originally derived their name from their ability to hedge against a market downturn by selling short. Though they may invest in stocks and bonds, hedge funds are typically considered an alternative asset class because of their ability to implement complex investing strategies that involve many other asset classes and investment options.

How do Hedge Funds Differ From Mutual Funds?
Quite simply, hedge funds are not available to the public.

Unlike mutual funds, hedge funds traditionally have not been offered for sale to the public at large; they are available only to a limited number of wealthy investors. The demand to participate in the most successful hedge funds can be so high that many funds are able to pick and choose who is permitted to invest.

Middle-Income Investors Need Not Apply
Investors normally must have a significant amount of money available to invest or have a high level of financial sophistication. For example, to invest in a hedge fund, an individual must have at least $1 million or an ongoing income of at least $200,000 in each of the two previous years ($300,000 if a spouse’s income is included). Depending on how the hedge fund is structured and the demand to participate, the minimum requirement can be much higher. Also, hedge funds usually require an investor to invest in the fund for a period of one year or longer and may limit transferability, making them a less liquid investment than mutual funds.

By contrast, mutual fund minimums are typically $1,000 or less, and investors may typically sell at any time (though some funds impose a fee for short holding periods).

Hedge Funds are not Required to Register with the SEC
Because they are not offered publicly and have limits on who may invest in them, most hedge funds are exempt from much of the regulation to which mutual funds are subject, though some hedge funds have registered with the SEC. Thought there have been attempts in recent years to increase supervision of hedge funds, their reporting requirements are minimal, though they are still subject to general prohibitions against securities fraud.

As a result, investors in hedge funds do not receive some of the protections that investors in mutual funds enjoy. In particular, hedge funds:

• Are not required to maintain a certain degree of liquidity
• Are not limited in how much they can invest in a single investment
• Are not limited in their use of leverage
• May take great latitude in determining the value of the fund’s investments, which does not have to be verified by independent sources
• Are not required to disclose information regarding the fund’s management, fees and expenses, holdings, or performance

As a result of this lax environment, hedge funds have a great deal more latitude in how they invest funds. They use a variety of investment types and strategies to try to minimize risk and maximize return including:

• Hedging: buying an investment that has the potential to offset losses in other investments
• Selling short: borrowing shares and selling them immediately, hoping that the price will drop and the shares can be replaced at a lower cost, thereby generating a profit.
• Arbitrage: simultaneously buying and selling the same security to take advantage of different prices
• Leverage: investing with borrowed money to try to maximize profitability
• Concentrating positions: making big investments in relatively few securities that are expected to be highly profitable
• Investing in distressed or bankrupt companies
• Investing in derivatives, such as options or futures contracts
• Investing in privately issued securities

How a given fund employs any or all of these techniques constitutes its unique investing strategy. Many of these techniques involve unique risks and pitfalls, and there have been some spectacular crises with hedge funds–notably Long Term Capital Management in 1998 and Amaranth Advisors in 2006–that used them.

Are Hedge Funds a Good Investment Option?
Since we deal with middle-market consumers, Lightship Mutual does not recommend hedge funds to our clients as an alternative asset class. Actually, even if we did work with a high-net worth individual, we would likely still not recommend investing in this ultra-risky asset class. We would likely construct an aggressive internationally-focused portfolio of low-cost mutual funds to accomplish a similar risk/return model.

The Downside of Hedge Funds
You could easily lose your entire investment.

As mentioned previously, hedge funds are able to use higher-risk investment strategies. Because of these risks and others, investors may lose their entire investment.

Second, because of the lack of regulation, a hedge fund’s investing strategy and performance can be difficult to research, verify and compare to other investments. Hedge funds are notoriously private about how they achieve their results, and may not disclose that information even to their own investors.

You may be able to check into the background of a hedge fund’s manager–for example, whether the manager has a disciplinary history in the securities industry-by going to the SEC’s web site and looking up the firm’s Form ADV. Depending on how the hedge fund is registered, you may be able to get information from the National Futures Association’s web site, your state securities regulator, or the Financial Industry Regulatory Authority (FINRA).

Third, hedge funds are typically more costly than mutual funds. Management fees for hedge funds are typically higher than actively managed mutual funds or separately managed accounts. Also, unlike mutual fund or other money managers, hedge fund managers generally receive a share of the fund’s gains. These added costs are passed on to the fund’s individual shareholders in the form of higher management and administrative fees when compared to mutual funds or separately managed accounts.

Fourth, hedge fund investments may lack liquidity. In most cases, hedge fund shares are not traded on any public exchange, so you may not be able to redeem your investment when you want to or at the price you paid.

Alternative Ways to Take Advantage of Hedge Funds
If you still have a burning desire to go forward with hedge fund investing–and have
tens of thousands of dollars to potentially lose–then you may be able to invest in a fund that invests not in securities but in multiple hedge funds. In most cases, the minimum investment is lower than that of a hedge fund–as low as $25,000–though that is still higher than the minimum of many mutual funds.

By investing in a variety of investing styles, managers and strategies, a fund of funds may provide greater diversification than a single hedge fund, though diversification alone cannot guarantee a profit or ensure against a loss.

As with hedge funds, a fund of funds may or may not be registered with the SEC; make sure you find out its status. Even if it is registered, remember that any SEC protections apply only to the fund of funds, not to the underlying hedge funds in which it invests.

Even if a fund of hedge funds is registered with the SEC, there may not be a secondary market and you could have difficulty selling your shares readily. Also, a fund of hedge funds is not required to redeem your shares at any time, as an open-ended mutual fund is.

Remember that you will be paying a double layer of fees: one set of fees to the fund of funds and, indirectly, another set of fees charged by each of the underlying hedge funds.

Good luck!

Capital Gains: Tax Time Considerations

It’s no fun to look at your mutual fund statement and realize that you’ve had losses for the year. It’s even more painful if you discover that, in addition to suffering a paper loss, you owe taxes on the fund’s distribution of capital gains. It’s a question that puzzles a lot of investors…How can you owe taxes on an investment that has lost money?

The answer has to do with the difference between your profit when you sell fund shares, and the fund’s profit when it sells individual securities. As a fund buys and sells securities during the year, it will typically have some gains and some losses. At the end of the year, losses are subtracted from gains to determine the fund’s shareholder distribution. The fund also may use losses from previous years to help offset gains.

By law, gains and/or income must be distributed each year; typically, those distributions occur around the end of the year and are taxable (unless the fund is held in a tax-advantaged account such as an IRA). Even if a fund is down at the end of that year, it may still have capital gains from earlier sales of securities.

Example: In 2002, Cesar’s stock fund bought 10,000 shares of XYZ Corporation for $33 a share. By the end of last year, the share price had reached $50, helping to push up the net asset value (NAV) the fund reported on its year-end statement to shareholders. This year, XYZ’s price drops to $43. The fund’s manager, concerned that XYZ might fall still further, sells the shares for a $100,000 profit. However, other shares held by the fund drop in value, and Cesar’s end-of-year statement now shows a lower balance compared to the year before. Because the fund did not sell shares to realize losses, it must still pass its $100,000 XYZ profit on to shareholders as capital gains distributions.

Good News, Bad News
Owing taxes on distributions from a fund that’s down is especially likely in years when a fund experiences substantial redemptions. If your fellow investors in a mutual fund have been pulling money out, the manager might have had to sell securities in order to meet those redemption demands. High market volatility also could mean a greater than usual level of capital gains distributions by funds with managers who traded actively, either to try to lock in gains or avoid further losses.

Some capital gains distributions this year may be affected by what happened in 2000-2002. Many funds that suffered during the bear market could use those losses in subsequent years to offset any capital gains and minimize that year’s taxable distribution. However, many funds have now used up their losses from the down years, leaving their managers with fewer leftover losses to offset any current gains from selling individual securities.

Tax Factors to Consider in Fund Selection
One way to minimize such problems is to consider a fund’s tax efficiency in advance. Taxes shouldn’t be the single deciding factor in any investment decision. However, when assessing the capital gains impact of a potential purchase, consider the following points:

• Some mutual funds tend to be more susceptible to the capital-gains dilemma than others. For example, funds with a high turnover ratio buy and sell more often and may generate more capital gains distributions.
• Some actively managed funds are designed specifically to be tax efficient, taking capital gains into account when making trading decisions.
• A fund’s long-term capital gains will be taxed at a more favorable rate than its short-term gains.
• Bond funds can experience capital gains and losses from the sale of individual bonds.
• Each mutual fund must report its after-tax return in its prospectus.

A (Small) Consolation
If you are squeezed by both a loss in your fund’s value and a capital gains distribution this year, remind yourself that at least the maximum tax rate on long-term capital gains and qualified dividends is 15% until January 1, 2011 (less if you’re in the 15% or 10% tax bracket).

You also may be able to offset capital gains from one mutual fund by taking a capital loss on another investment. A financial professional can help you assess the potential tax impact of a given mutual fund, as well as the best way to manage any capital gains liability.

Absolute Return Investing: Aiming for Market Independence

Wouldn’t it be great if you could reduce your portfolio’s risk by some means other than simply reducing or eliminating your investments in highly volatile asset classes? Well, that’s the goal of absolute return investing. However, as with all investments, there’s a trade off. To try to reduce market risk, you’ll probably increase your exposure to other types of risk.

Benchmarks and Absolute Return
An investment typically is measured relative to its benchmark’s performance. For example, a negative return might still be considered successful if the loss was less than that of the benchmark to which it is compared. And an investment might have positive returns simply because its asset class is doing well.

By contrast, absolute return, or market-neutral, strategies attempt to make money each year–or at least not lose it–no matter what’s happening with the market. An absolute return portfolio’s performance benchmark might be the risk-free return on cash. For example, a manager might aim for a return equal to that of a short-term bank deposit plus three or four percentage points. (Of course, as with any investment, there’s no guarantee that it will achieve its goal.)

The Long and Short of Investing
Many absolute return investments attempt to eliminate market risk–that is, be market-neutral–by adopting so-called long-short strategies, which rely on the difference between being “long” and selling short. Short selling involves borrowing shares or other securities and selling them, in the belief that the price will drop and you will be able to buy them for less when you must replace them later. The difference between the price you got when you sold the shares and the price you paid to replace them is your profit. However, you also can lose money if the price rises and you must pay more to replace the borrowed shares than you got for them.

A short sale is bearish. By contrast, being long–buying a security outright–is a bullish position; if you think an investment will decrease in value, you probably won’t buy it.

Trying to Have it Both Ways
Market-neutral strategies try to have the best of both worlds by investing in both long and short positions, typically in equal proportion. For example, a manager might buy a security he or she considers undervalued, and sell short an equal dollar amount of a similar security that appears overvalued. The opposing long and short positions are designed to neutralize the ups and downs of that particular market–hence the name–and reduce a portfolio’s volatility. Because it strives to be independent of market behavior, a market-neutral portfolio’s performance is based almost exclusively on its manager’s ability to identify and trade under- and overvalued securities.

But wait–isn’t that exactly what an actively managed mutual fund does? Yes, but the typical mutual fund manager who’s concerned about a particular security or sector either invests less in it or avoids it. A market-neutral manager might actually short that sector or security, actively attempting to take advantage of its problems. In some ways, a market-neutral fund is the mirror image of an index mutual fund. Because an index fund is designed to replicate a particular market, it is 100% exposed to market risk; a market-neutral portfolio takes the opposite approach.

If It’s Not One Thing, It’s Another
Of course, even if a portfolio manages to be independent of market risk, that doesn’t mean it’s eliminated other risks. A market-neutral portfolio’s manager can misjudge which securities to buy or short, or the timing of those trades; also, there are specific risks associated with each individual security. Any of the above can have as unexpected and dramatic an impact as overall market movements. Though absolute return investing attempts to lower volatility and achieve a positive return, there are no guarantees it will do so, and it may not be appropriate for all investors.

Seeking Absolute Return
Hedge funds and institutional investors often rely on absolute return investing. However, in recent years, mutual funds with similar strategies have expanded the concept to a broader range of investors. A fund may focus on a single asset class, or include multiple asset classes as well as global investments.

If you’re considering an absolute return fund, you’ll need to pay attention to costs; a greater level of complexity can increase trading expenses. Consider also how a given strategy has fared in both up and down markets. Consult a financial professional to see if absolute return investing makes sense for part of your portfolio.

Mutual Fund Investing Basics

When investing in a mutual fund, you may have the opportunity to choose among several share classes, most commonly Index, Class A, Class B, and Class C. The differences among these share classes typically revolve around how much you will be charged for buying the fund, when you will pay any sales charges that apply, and the amount you will pay in annual fees and expenses. This multi-class structure offers you the opportunity to select a share class that is best suited to your investment goals.

The Index Way is the Only Way
Let’s be very clear up front. Our advisors only recommend no-load index funds to clients. With their minimal annual costs and tax efficient structures, index funds are an easy favorite at Lightship Mutual.

So you ask, if index funds are so great, then why do we need Class A, Class B, and Class C mutual fund shares anyway? Great question! Well, it all has to do with a little something called “commission”. In the old days, you had to pay a sharply-dressed stockbroker to purchase your mutual fund shares for you. And in exchange, you paid him/her a commission of 5-10% to do so.

But then then the whole Internet revolution came along, and what do you know…now we can purchase our mutual fund shares directly from the fund companies and cut out the middle man (and his $2000 Italian suit). Ain’t life grand? At any rate, it is still important for you to know what the other various classes of funds are, just in case someone ever tries to pitch them to you.

The Costs Associated with Mutual Funds
Typically, mutual fund costs consist of two different fees: the initial sales charges and the annual expense. The sales charge, often called a “load”, is the broker’s commission, deducted from your investment when you buy the fund, or when you sell it. The annual expenses cover the fund’s operating costs, including management fees, distribution and service fees (commonly known as 12b-1 fees), and general administrative expenses. They are generally computed as a percentage of your assets and then deducted from the fund before the fund’s returns are calculated. (To better understand what these charges are, you should review the Fees and Expenses section of the fund’s prospectus.)

Class A Shares
When you purchase Class A shares, an up front sales charge, called a front-end load, is typically deducted, thus reducing the actual amount of your initial investment. For example, suppose you decide to spend $1,000 on Class A shares with a hypothetical front-end sales load of 5 percent. You will be charged $50 on your purchase, and only $950 will be invested. You lost fifty dollars just like that…Ouch!

Class B Shares
Unlike Class A shares, there is no up-front sales charge, so all of your initial investment is put to work immediately. However, Class B shares do have a back-end load, often called a contingent deferred sales charge (CDSC) that you pay when you sell your shares. The load usually decreases over time (typically 6 to 8 years), although this varies from fund to fund. By the end of the time period no charge applies. At that stage your shares may convert to Class A shares.

For example, suppose you invest $5,000 in Class B shares, with a 5 percent CDSC that decreases by 1 percent every year after the second year. If you sell your shares within the first year, you will pay 5 percent of the value of your assets or the value of the initial investment, whichever is less. If you hold your shares for 6 years, the CDSC will be reduced to zero.

Class C Shares
When you purchase Class C shares, a front-end load is normally not imposed, and the CDSC is generally lower than for Class B shares. This charge is reduced to zero if you hold the shares beyond the CDSC period, which for Class C shares is typically 12 months.

Do Your Homework
Don’t just take our word for it. Grab and pencil and paper and check out the National Association of Securities Dealers (NASD) at www.nasd.com. You can also find information on the Securities and Exchange Commission (SEC) website at www.sec.gov.

As you consider how best to invest in mutual funds, remember that there’s no guarantee any mutual fund will achieve its investment objective. You should discuss all of your investment goals with a qualified financial professional.

Are Variable Annuities Right for You?

A variable annuity is a contract between an individual (the purchaser) and an insurance company (the insurer). In return for premium payments, the insurer agrees to make periodic payments to the purchaser (if the purchaser elects this option), beginning either immediately or at some future date. Deposits can be made by either a single purchase payment or a series of purchase payments.

Purchasers of variable annuities have some control over the manner in which their annuity premiums are invested (unlike fixed annuities). The investment options (or sub accounts) for a variable annuity will usually include stocks, bonds, money market instruments, or some combination of the three. As the purchaser, you can designate how your premium dollars will be allocated among the offered investment choices.

Variable Annuity Features
Like all annuities, variable annuities possess a unique combination of attributes:

• Tax deferral: Taxes on the income and investment gains from the annuity are deferred until money is withdrawn. Note that all distributed earnings are taxed at ordinary income tax rates and never at capital gains rates. Distributions taken before age 59½ are subject to a 10 percent early withdrawal penalty tax on earnings.
• Periodic payments: Proceeds can be distributed in periodic payments for the life of the annuitant, or for the lives of the annuitant and a spouse (or some other person). If this option is elected, the annuitant cannot outlive the payment stream.
• Death benefits: If an annuitant dies before reaching the annuity payout date, his or her beneficiary is generally guaranteed a death benefit. (Guarantees are subject to the claims-paying ability of the issuing insurance company.) The amount of the death benefit is usually the greater of an amount specified in the annuity contract, or the amounts contributed to the contract and the investment income credited to the contributions, reduced by any withdrawals made from the annuity. Annuity proceeds paid at the death of the annuitant will bypass probate if left to a named beneficiary.
• The funds in an annuity are generally unreachable by creditors (laws vary by state).

The Phases: Accumulation and Payout
Like other annuities, there are two phases to a variable annuity: the accumulation phase and the payout phase.

During the accumulation phase, you (as the purchaser of the annuity) make payments that are allocated to the various investment options. You can typically transfer funds from one investment option to another without paying tax on the investment income and gains.

After the accumulation phase, the funds are paid out (the payout phase). At the beginning of the payout phase, you generally elect how you want to take payouts–in a lump sum, as funds are needed, or annuitized over your life, the joint life of you and another individual, or over a specific period of time.

The amount of each periodic payment you receive depends in part, of course, on how you elect to take payouts.

The Death Benefit
Variable annuities commonly provide a death benefit. The amount of the death benefit may be specified in the annuity contract, or it may be calculated as the greater of some guaranteed minimum (e.g., all purchase payments minus withdrawals) or all the moneys in the account at the time of death. (Guarantees are subject to the claims-paying ability of the issuing insurance company.)

Many variable annuities allow you to choose a stepped-up death benefit for an additional charge. The stepped-up benefit is a higher guaranteed death benefit, for which the insurance company charges extra premiums. The advantage of these benefits is that you will know with some certainty how much your beneficiary will receive when you die.

A number of other optional benefits can be purchased as part of a variable annuity policy to guarantee higher streams of payments. Of course, these benefits add to the cost of purchasing the annuity.

Annuity Fees
Among the many major differences between mutual funds and variable annuities are the relatively high fees charged to annuity holders. But with variable annuities, the sales load is a substantial up-front amount the consumer must pay to buy into the contract, combined with an ongoing yearly maintenance fee, and finally a surrender charge, which is applied only on withdrawals during the initial years after purchase, usually about seven years.

All of these miscellaneous fees go directly into your stockbroker’s pockets (Hey, muli-billion dollar international stock brokerage firms have to eat too! How else can they afford the Lear jets and a decent Ivy League education for Junior? Have a heart!)

Are Variable Annuities Right For You?
We very rarely advise our clients to invest in variable annuities. There are some cases–only if you’ve already maxed out your Roth IRA and 401k for the year in which you may look into a fixed annuity option. Otherwise, if you are under 40, your best bet to facilitate growth and minimize costs (go back and count the number of times we used the words “load” and “fee “above”) is to stick with low-cost, no load index mutual funds. A diversified mix of quality index funds remains our favorite strategy, and we will continue to steer client away from the variable annuity trap.

Health Savings Accounts: Just What the Doctor Ordered?

Are health insurance premiums taking too big of a bite out of your budget? Do you wish you had better control over how you spend your health-care dollars? If so, you may be interested in an alternative to traditional health insurance called a health savings account (HSA).

How Does a Health Savings Account work?
An HSA is a tax-advantaged account that’s paired with a high-deductible health plan (HDHP). Let’s look at how an HSA works with an HDHP to enable you to cover your current health-care costs and also save for your future needs.

Before opening an HSA, you must first enroll in an HDHP, either on your own or through your employer. An HDHP is “catastrophic” health coverage that pays benefits only after you’ve satisfied a high annual deductible. (Some preventative care, such as routine physicals, may be covered without being subject to the deductible.) For 2007, the annual deductible for an HSA-qualified HDHP must be at least $1,100 for individual coverage and $2,200 for family coverage. However, your deductible may be higher, depending on the plan.

Once you’ve satisfied your deductible, the HDHP will provide comprehensive coverage for your medical expenses (though you may continue to owe co-payments or coinsurance costs until you reach your plan’s annual out-of-pocket limit). A qualifying HDHP must limit annual out-of-pocket expenses (including the deductible) to no more than $5,500 for individual coverage and $11,000 for family coverage (for 2007). Once this limit is reached, the HDHP will cover 100% of your costs, as outlined in your policy.

Because you’re shouldering a greater portion of your health-care costs, you’ll usually pay a much lower premium for an HDHP than for traditional health insurance, allowing you to contribute the premium dollars you’re saving to your HSA. Your employer may also contribute to your HSA, or pay part of your HDHP premium. Then, when you need medical care, you can withdraw HSA funds to cover your expenses, or opt to pay your costs out-of-pocket if you want to save your account funds.

An HSA can be a powerful savings tool. Because there’s no “use it or lose it” provision, funds roll over from year to year. And the account is yours, so you can keep it even if you change employers or lose your job. If your health expenses are relatively low, you may be able to build up a significant balance in your HSA over time. You can even let your money grow until retirement, when your health expenses are likely to be substantial. However, HSAs aren’t foolproof. If you have relatively high health expenses (especially within the first year or two of opening your account, before you’ve built up a balance), you could deplete your HSA or even face a shortfall.

HSA as a Tool for Tax Reduction

HSAs offer several valuable tax benefits:

• You may be able to make pretax contributions via payroll deduction through your employer, reducing your current income tax.
• If you make contributions on your own using after-tax dollars, they’re deductible from your federal income tax (and perhaps from your state income tax) whether you itemize or not. You can also deduct contributions made on your behalf by family members.
• Contributions to your HSA, and any interest or earnings, grow tax deferred.
• Contributions and any earnings you withdraw will be tax free if they’re used to pay qualified medical expenses.

Consult a tax professional if you have questions about the tax advantages offered by an HSA.

Can Anyone Open an HSA?

Any individual with qualifying HDHP coverage can open an HSA. However, you won’t be eligible to open an HSA if you’re already covered by another health plan (although some specialized health plans are exempt from this provision). You’re also out of luck if you’re 65 and eligible for Medicare or if you can be claimed as a dependent on someone else’s tax return.

How Much Can I Contribute to an HSA?

Each year, you can contribute up to $2,850 for individual coverage and $5,650 for family coverage (for 2007). This limit applies to all contributions, whether they’re made by you, your employer, or your family members. You can make contributions up to April 15th of the following year (i.e., you can make 2007 contributions up to April 15, 2008). If you’re 55 or older, you may also be eligible to make “catch-up contributions” to your HSA, but you can’t contribute anything once you reach age 65.

Note: Starting in 2007, you’ll be able to make a one-time tax-free rollover of funds to your HSA from a health flexible spending account (FSA), a health reimbursement arrangement (HRA), or a traditional IRA (certain limits apply).

Can I Invest My HSA funds?
HSAs typically offer several savings and investment options. These may include interest-earning savings, checking, and money market accounts, or investments such as stocks, bonds, and mutual funds that offer the potential to earn higher returns but carry more risk (including the risk of loss of principal). Make sure that you carefully consider the investment objectives, risks, charges, and expenses associated with each option before investing. A financial professional can help you decide which savings or investment options are appropriate.

How Else Can I Use My HSA Funds?
You can use your HSA funds for many types of health-care expenses, including prescription drugs, eyeglasses, deductibles, and co-payments. Although you can’t use funds to pay regular health insurance premiums, you can withdraw money to pay for specialized types of insurance such as long-term care or disability insurance. IRS Publication 502 contains a list of allowable expenses.

There’s no rule against using your HSA funds for expenses that aren’t health-care related, but watch out–you’ll pay a 10% penalty if you withdraw money and use it for nonqualified expenses, and you’ll owe income taxes as well. Once you reach age 65, however, this penalty no longer applies, though you’ll owe income taxes on any money you withdraw that isn’t used for qualified medical expenses.

What is a Self-Directed IRA?

A self-directed IRA isn’t a different type of IRA. Rather, the term refers to any individual retirement account (traditional or Roth) that gives you more investment control by allowing you to direct your IRA assets into nontraditional investments.

For example, in addition to the usual IRA mainstays (stocks, bonds, mutual funds, and CDs), a self-directed IRA might invest in real estate, options, limited partnership interests, or anything else the law (and your IRA trustee/custodian) allows. In fact, the only investment you can’t have in an IRA is life insurance. (Collectibles–for example, artwork, stamps, wine, and antiques–aren’t prohibited, but if your IRA purchases these items, you could suffer adverse tax consequences.)

Get A Specialist
To get started, you’ll need to find a trustee or custodian that specializes in self-directed IRAs. Make sure you understand the expenses involved–some trustees charge transaction fees and/or asset-based fees, depending on the particular investment.
You also need to be aware of the prohibited transaction rules. These rules are designed to make sure that only your IRA, and not you (or your immediate family), benefits from your IRA transactions. For example, you are prohibited from buying investments from, or selling investments to, your IRA. If you violate these rules, your account will cease to be treated as an IRA, with potentially devastating tax consequences.

Understand the Additional Costs
Finally, you need to understand the UBIT (unrelated business income tax) rules. Even though IRA investments usually grow tax deferred (or even potentially tax free in the case of a Roth IRA), if your IRA conducts certain business activities, or has debt-financed income, then your IRA could be taxed currently on all or part of the income generated.

Although we don’t generally recommend these alternative IRA accounts, a qualified financial professional can help you weigh the benefits and risks of a self-directed IRA…and help you determine if it’s the right choice for you.

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