Saving for Retirement and a Child’s Education at the Same Time

Understanding Social Security

Understanding the IRA

An Individual Retirement Account (IRA) is a personal savings vehicle that offers specific tax benefits. IRAs are one of the most powerful retirement savings tools available to you. Even if you’re contributing to a 401 at work, you should consider opening an IRA and other accounts as well.

It is important to point out that an IRA is an account that holds investments such as mutual funds, stocks, and bonds. An IRA, in itself, is not an investment, so it would be incorrect to say that “I bought $500 worth of IRAs”. The correct statement would be “I bought $500 worth of mutual funds within my IRA account.”

What Types of IRAs are Available?
The two major types of IRAs:

1. Traditional IRA
2. Roth IRA

Both allow you to contribute as much as $4,000 in 2006 and 2007. You must have at least as much (taxable) earned income as the amount of your IRA contribution. But if you are married filing jointly, your spouse can also contribute to an IRA, even if he or she does not have taxable compensation. The law also allows taxpayers age 50 and older to make additional “catch-up” contributions. They can contribute up to $5,000 in 2006 and 2007.

Both traditional and Roth IRAs feature tax-sheltered growth of earnings. And both give you a wide range of investment choices. However, there are important differences between the two, and you must understand these differences before you can choose the type that’s best for you.

Note: If you were affected by Hurricanes Katrina, Rita, or Wilma, or if you are a reservist called to active duty after September 11, 2001 and before December 21, 2007, special rules may apply to you.

Learn the Rules for Traditional IRAs
Practically anyone can open and contribute to a traditional IRA. The only requirements are that you must have taxable compensation and be under age 70½. You can contribute the maximum allowed each year as long as your taxable compensation for the year is at least that amount. If your taxable compensation for the year is below the maximum contribution allowed, you can contribute only up to the amount that you earned. The tax implications can get tricky, but here is a quick overview of the benefits…

Your contributions to a traditional IRA may be tax deductible on your federal income tax return. This is important because tax-deductible (pretax) contributions lower your taxable income for the year, saving you money in taxes. If neither you nor your spouse is covered by a 401(k) or other employer-sponsored plan, you can generally deduct the full amount of your annual contribution. If one of you is covered by such a plan, your ability to deduct your contributions depends on your annual income and your income tax filing status. You may qualify for a full deduction, a partial deduction, or no deduction at all.

Withdrawing Money From a Traditional IRA
Any portion of a distribution that represents deductible contributions is subject to income tax because those contributions were not taxed when you made them. Any portion that represents investment earnings is also subject to income tax because those earnings were not previously taxed either. Only the portion that represents nondeductible, after-tax contributions (if any) is not subject to income tax. In addition to income tax, you may have to pay a 10 percent early withdrawal penalty if you’re under age 59½, unless you meet one of the exceptions.

If you wish to defer taxes, you can leave your funds in the traditional IRA, but only until April 1 of the year following the year you reach age 70½. That’s when you have to take your first required minimum distribution from the IRA. After that, you must take a distribution by the end of every calendar year until you die or your funds are exhausted. The annual distribution amounts are based on a standard life expectancy table. You can always withdraw more than you’re required to in any year. However, if you withdraw less, you’ll be hit with a 50 percent penalty on the difference between the required minimum and the amount you actually withdrew.

The Roth IRA
Not everyone can set up a Roth IRA. Even if you can, you may not qualify to take full advantage of it. The first requirement is that you must have taxable compensation. If your taxable compensation for the year is at least $4,000 (for 2006 and 2007), you may be able to contribute the full $4,000. But it gets more complicated. Your ability to contribute to a Roth IRA in any year depends on your adjusted gross income and your income tax filing status. Your allowable contribution may be less than the maximum possible, or nothing at all.

Your contributions to a Roth IRA are not tax deductible. You can invest only after-tax dollars in a Roth IRA. The good news is that if you meet certain conditions, your withdrawals from a Roth IRA will be completely income tax free, including both contributions and investment earnings. To be eligible for these qualifying distributions, you must meet a five-year holding period requirement. In addition, one of the following must apply:

• You have reached age 59½ by the time of the withdrawal
• The withdrawal is made because of disability
• The withdrawal (of up to $10,000) is made to pay first-time home-buyer expenses
• The withdrawal is made by your beneficiary or estate after your death

Qualifying distributions will also avoid the 10 percent early withdrawal penalty. This ability to withdraw your funds with no taxes or penalties is a key strength of the Roth IRA. And remember, even non-qualifying distributions will be taxed (and possibly penalized) only on the investment earnings portion of the distribution, and then only to the extent that your distribution exceeds the total amount of all contributions that you have made.

Another advantage of the Roth IRA is that there are no required distributions after age 70½ or at any time during your life. You can put off taking distributions until you really need the income. Or, you can leave the entire balance to your beneficiary without ever taking a single distribution. Also, as long as you have taxable compensation and qualify, you can keep contributing to a Roth IRA after age 70½.

Which IRA is Best for You?
Sometimes the choice is easy. The Roth IRA will probably be a more effective tool if you don’t qualify for tax-deductible contributions to a traditional IRA. However, if you can deduct your traditional IRA contributions, the choice is more difficult. The Roth IRA may very well make more sense if you want to minimize taxes during retirement and preserve assets for your beneficiaries. But a traditional deductible IRA may be a better tool if you want to lower your yearly tax bill while you’re still working (and probably in a higher tax bracket than you’ll be in after you retire). A qualified financial planner or tax advisor can help you pick the right type of IRA for you.

Note: You can have both a traditional IRA and a Roth IRA, but your total annual contribution to all of the IRAs that you own cannot be more than $4,000 for 2006 and 2007 ($5,000 in 2006 and 2007, if age 50 or older).

Tax Planning for the Self Employed

Self-employment. The opportunity to be your own boss. To come and go as you please. Oh and we can’t forget…the opportunity to establish a lifelong bond with your accountant. If you’re self-employed, you’ll need to pay your own FICA taxes and take charge of your own retirement plan, among other things. Here are some planning tips.

Understand Self-Employment Tax and How It’s Calculated
As a starting point, make sure that you understand (and comply with) your federal tax responsibilities. The federal government uses self-employment tax to fund Social Security and Medicare benefits. You must pay this tax if you have more than a minimal amount of self-employment income. If you file a Schedule C as a sole proprietor, independent contractor, or statutory nonemployee, the net profit listed on your Schedule C (or Schedule C-EZ) is self-employment income and must be included on Schedule SE, which is filed with your federal Form 1040. Schedule SE is used both to calculate self-employment tax and to report the amount of tax owed.

Make Your Estimated Tax Payments on Time to Avoid Penalties
Employees generally have income tax, Social Security tax, and Medicare tax withheld from their paychecks. But if you’re self-employed, it’s likely that no one is withholding federal and state taxes from your income. As a result, you’ll need to make quarterly estimated tax payments on your own to cover your federal income tax and self-employment tax liability. You’ll probably have to make state estimated tax payments, as well. If you don’t make estimated tax payments, you may be subject to penalties, interest, and a big tax bill at the end of the year. Oh, and if you do have employees, you’ll have additional periodic tax responsibilities. You’ll have to pay federal employment taxes and report certain information.

Employ Family Members to Save Taxes
Hiring a family member to work for your business can create tax savings for you; in effect, you shift business income to your relative. Your business can take a deduction for reasonable compensation paid to an employee, which in turn reduces the amount of taxable business income that flows through to you. Be aware, though, that the IRS can question compensation paid to a family member if the amount doesn’t seem reasonable, considering the services actually performed. Also, when hiring a family member who’s a minor, be sure that your business complies with child labor laws.

As a business owner, you’re responsible for paying FICA (Social Security and Medicare) taxes on wages paid to your employees. The payment of these taxes will be a deductible business expense for tax purposes. However, if your business is a sole proprietorship and you hire your child who is under age 18, the wages that you pay your child won’t be subject to FICA taxes.

As is the case with wages paid to all employees, wages paid to family members are subject to withholding of federal income and employment taxes, as well as certain taxes in some states.

Establish an Employer-Sponsored Retirement Plan for Tax (and Non-Tax) Reasons
Because you’re self-employed, you’ll need to take care of your own retirement needs. You can do this by establishing an employer-sponsored retirement plan, which can provide you with a number of tax and nontax benefits. With such a plan, your business may be allowed an immediate federal income tax deduction for funding the plan. You can also generally place pretax dollars into a retirement account to grow tax deferred until withdrawal. You may want to use one of the following types of retirement plans:

• Keogh plan
• Simplified employee pension (SEP)
• SIMPLE IRA
• SIMPLE 401(k)
• Individual (or “solo”) 401(k)

The type of retirement plan that your business should establish depends on your specific circumstances. Explore all of your options and consider the complexity of each plan. And bear in mind that if your business has employees, you may have to provide coverage for them as well. For more information about your retirement plan options, consult a qualified tax professional.

Take Advantage of Business Deductions to Lower Taxable Income
Because deductions lower your taxable income, you should make sure that your business is taking advantage of any business deductions to which it is entitled. You may be able to deduct a variety of business expenses, including rent or home office expenses, and the costs of office equipment, furniture, supplies, and utilities. To be deductible, business expenses must be both ordinary (common and accepted in your trade or business) and necessary (appropriate and helpful for your trade or business). If your expenses are incurred partly for business purposes and partly for personal purposes, you can deduct only the business-related portion.

If you’re concerned about lowering your taxable income this year, consider the following possibilities:

• Deduct the business expenses associated with your motor vehicle, using either the standard mileage allowance or your actual business-related vehicle expenses to calculate your deduction
• Buy supplies for your business late this year that you would normally order early next year
• Purchase depreciable business equipment, furnishings, and vehicles this year
• Deduct the appropriate portion of business meals, travel, and entertainment expenses
• Write off any bad business debts

Self-employed taxpayers who use the cash method of accounting have the most flexibility to maneuver at year-end. See a tax specialist for more information.

Deduct Health-Care Related Expenses
If you qualify, you may be able to benefit from the self-employed health insurance deduction, which would enable you to deduct up to 100 percent of the cost of health insurance that you provide for yourself, your spouse, and your dependents. This deduction is taken on the front of your federal Form 1040 (i.e., “above-the-line”) when computing your adjusted gross income, so it’s available whether you itemize or not. The portion of your health insurance premiums that is not deductible there can be added to your total medical expenses itemized in Schedule A.

Contributions you make to a health savings account (HSA) are also deductible “above-the-line.” An HSA is a tax-exempt trust or custodial account you can establish in conjunction with a high-deductible health plan to set aside tax-free funds for health-care expenses.

The Full Spectrum of Wealth Management

Perhaps you’re fortunate enough to be considered wealthy–maybe even very wealthy. If so, you know that wealth alone doesn’t fulfill all your dreams; in fact, it may create a few challenges of its own. Where can you turn for advice tailored to your level of wealth? The answer may be wealth management.

What is Wealth Management?
Wealth management offers an individually customized array of sophisticated financial planning services to high-net-worth clients. These services may include banking, investment portfolio management, asset and trust management, legal services, taxation advice, protection planning, and estate planning. Services may be provided by a team of professionals under one roof; alternatively, a wealth manager may coordinate the efforts of a customized network of professionals who specialize in the areas relating to your needs.

Wealth managers work with you to articulate and understand the hopes, dreams, and goals you really want to fulfill with your wealth, then craft solutions to help. These plans focus not only on accumulating wealth, but also on protecting and distributing it, both during your lifetime and after your death.

Managing What You Have
You’ve already been successful at accumulating wealth; now you need to optimize the degree that your dollars work for you. Wealth managers may ask probing questions to help paint a picture of your fundamental desires, and then recommend investment vehicles, asset allocations, and even borrowing strategies designed to help you most effectively obtain all you’ll need to fulfill those dreams at a level of risk you’re comfortable with.

Minimizing Your Risk
As you accumulate your wealth, you’ll need to have measures in place to protect it. What if the market changes–will your investments still be allocated appropriately? Are your assets structured in the best possible way to minimize taxes, not only as you accumulate them, but also as you distribute them during your lifetime and after your death? And what would happen to your plan if you were to fall ill, become disabled, need long-term medical care, or die?

A wealth manager may recommend adjustments to your investment portfolio as the financial weather changes, structure tax-advantaged investment vehicles most congruent with your goals and timetable, and suggest life, health, disability, and long-term care insurance products appropriate for your situation.

Deciding What to Take When
In most cases, you’ll have accumulated your wealth to provide (at least in part) for your own retirement needs. But what will your needs be? Wealth managers help you assess your anticipated retirement lifestyle and its cost, the assets you’ll have to meet that cost, and the best ways to “cash in” those assets–everything from when to start collecting your pension payments to how much and in what order to draw against your investments.

Leaving a Legacy
Perhaps you want to help your heirs get a “leg up” in life, or maybe you want to engage in philanthropy, or both. Wealth managers can help you explore what’s most important to you when it comes to leaving a legacy, and can devise strategies (e.g., trusts, beneficiary designations, and leveraging transfer tax allowances and gift tax exclusions) to help you make your dreams a reality.

Don’t just dream about what you want–reach for it. A wealth management team can help you find creative solutions to fit all your financial needs.

How Long Will You Live? And Why Does It Matter?

Since the oldest baby boomers are now reaching retirement age, a lot of national attention has focused on this growing number of older Americans. We can all expect to live many years in retirement, but Social Security and Medicare will be strained. To make matters worse, most people are saving less than they should. Planning for a long, secure retirement has now become more important than ever.

Life Expectancy Trends
Gains in life expectancy over the last century have been dramatic. According to the National Center for Health Statistics (NCHS), from 1900 through 2004 (the most recent year for which statistics are available), life expectancy at birth for the total population increased from 47 to 78. Much of the gain in life expectancy at birth came in the first half of the 20th century, as public health projects and scientific discoveries helped control many of the infectious diseases and unsanitary conditions that led to a high number of childhood deaths.

Life expectancy for individuals who reach age 65 has also been steadily increasing. According to the NCHS, life expectancy for older individuals improved mainly in the latter half of the 20th century, due largely to advances in medicine, better access to health care, and healthier lifestyles. Someone reaching age 65 in 1950 could expect to live approximately 14 years longer (until about age 79), while someone reaching age 65 in 2004 could expect to live approximately 19 years longer (until about age 84).

Reduce the Odds of Outliving Your Money
Using life expectancy tables or calculators to estimate how long you’ll live can help you plan for retirement. Once you understand how many years you might spend in retirement, it may be easier for you and your financial professional to put together a realistic plan to help ensure that your retirement funds will last for a lifetime.

Here are a few planning tips:

• Prepare for several financial scenarios. For example, how much money will you need if you live to age 75? Age 85? Age 95?
• Recalculate your life expectancy periodically. Statistically, life expectancy changes over time.
• Consider your spouse’s life expectancy as well as your own when determining your retirement income needs. According to NCHS statistics, women live 5 years longer than men, on average, although the gap is slowly closing.
• Plan for the possibility of needing long-term care. The longer you live, the greater the chance that you’ll need assistance with day-to-day tasks or even expensive nursing home care that could wipe out your retirement savings.

How To Handle an Inherited 401(k) Plan Account

When you inherit a 401(k) plan account, the options available to you depend on a number of factors, including the terms of the 401(k) plan and your relationship to the deceased 401(k) plan participant. In general, you’ll have four options: take an immediate distribution, disclaim all or part of the assets, leave the money in the 401(k) plan (if the plan permits), or roll the funds over to an IRA.

Should You Take the Cash?
Obviously, if you need the funds immediately, taking a lump-sum distribution from the 401(k) plan may be your only viable alternative. But you’ll have to pay ordinary income tax on the distribution (certain exclusions apply; talk to your financial professional for details).

A lump sum might also be attractive if you’re entitled to a distribution of employer stock. You may be able to pay ordinary income tax on just the participant’s basis in the stock, and defer tax on the appreciation (also called “net unrealized appreciation”) until you sell the stock in the future–at capital gain rates.

What’s a Disclaimer?
When you disclaim (i.e., refuse to accept) 401(k) assets, they pass instead to the plan participant’s contingent beneficiary, or estate if there is no contingent beneficiary. In general, you must give the plan written notice of your intent to disclaim the funds within nine months after the participant’s death. But be careful not to exercise control over the funds in the meantime (for example, by choosing a distribution option or by exercising investment control), or you may lose your ability to disclaim the funds.

A disclaimer may be an attractive option if you’re sure you won’t need the funds, and the transfer to the contingent beneficiary makes good economic and estate planning sense.

The Problem With 401(k) Plans
If you’re like most beneficiaries, your goal will be to stretch payments out as long as possible, taking full advantage of the tax deferral offered by retirement plans. This means either leaving the assets in the 401(k) plan, or rolling them over to an IRA.

For most, leaving the funds in the 401(k) plan isn’t the best choice for two reasons. First, the investment alternatives available to you in a 401(k) plan are limited to the ones selected by the employer. Second, the distribution options offered by a 401(k) plan typically aren’t as flexible as those available in an IRA. In fact, many 401(k) plans require beneficiaries to take distributions shortly after the participant’s death.

Roll the Funds Over to an IRA
Unless the 401(k) plan offers a unique investment alternative, rolling the 401(k) assets over to an IRA will usually be your best choice. IRAs offer virtually limitless investment options. And when it comes time to take distributions from the plan, IRAs offer the most flexible payment provisions. But, before deciding on a rollover, make sure you understand any fees and expenses that may apply.

If you’re a surviving spouse, you’ll have to decide between rolling the funds over to your own IRA, or to an IRA that you establish in the participant’s name, with you specified as the beneficiary (this is referred to as an “inherited IRA”).

Which Should you Choose?
In most cases, spouses are better off rolling the funds over to their own IRA. A rollover is typically appropriate only if you’re younger than 59½ and you think you’ll need the funds before you reach that age. That’s because distributions from an inherited IRA aren’t subject to the 10% early distribution penalty tax. (In contrast, distributions from your own IRA before age 59½ are subject to the 10% penalty tax unless an exception applies.)

What About Non-Spouses?
If you’re not the surviving spouse, you don’t have the option of rolling the 401(k) assets over to your own IRA. But thanks to the Pension Protection Act of 2006, you may be able to make a direct rollover of the 401(k) funds to an inherited IRA. A 401(k) plan isn’t required to offer this option, so check with your plan administrator. This new rule applies to distributions you receive after 2006.

The rules governing inherited 401(k) plan accounts are complex. A financial advisor can help you sort through the alternatives, and make the decision most appropriate for your individual circumstances.

The Buzz on Estate Tax

The Economic Growth and Tax Relief Act of 2001 gradually phases out the federal estate tax until its complete repeal in 2010. However, under the same law, the estate tax is scheduled to return in 2011.

Since 2001, there have been a number of failed attempts to make the estate tax repeal permanent. In fact, there are still several bills in Congress that include provisions to eliminate this tax. While it’s clear President Bush would sign such legislation, the recent changes in Congress make it less likely he’ll get the chance to do so. The question remains, though: Will permanent repeal become law, and if so, what are the potential ramifications?

Good-bye Estate Tax; Hello Capital Gains
Repeal does not mean that tax on wealth transfers from one generation to the next will disappear. While currently a tax is imposed on estates, after repeal, a tax will be imposed indirectly on inheritances in the form of capital gains tax. Here’s a simplified explanation.

Under the current tax system, property that is transferred to heirs at the owner’s death typically gets a “step-up” in tax basis to the current fair market value. Generally, tax basis refers to the cost the owner paid to acquire the property, and is used to compute capital gains tax when the property is sold.

On the other hand, when property is transferred by gift, the recipient receives a “carryover” basis; the tax basis in the hands of the person making the gift generally becomes the recipient’s tax basis.

One of the consequences of estate tax repeal in 2010 will be that the step-up in tax basis will be lost. Heirs will receive a carryover basis on inherited property, and will recognize the capital gain (or loss) when the property is sold at some point in the future.

The Impact on You
According to the IRS, estate tax affects only 2% of Americans. Capital gains tax, though, can affect anyone who owns capital assets such as real estate, buildings, and industrial equipment. Therefore, unless the step-up in basis remains, estate tax repeal is likely to result in creating a higher tax bill for a greater percentage of less-wealthy Americans. Further, repeal will create a paperwork headache for heirs who will have to determine the decedent’s tax basis in the property they’ve inherited.

Pros and Cons of Permanent Repeal
Proponents of permanent repeal regard the estate tax as morally unfair and an obstacle to family business continuity and growth. Critics call permanent repeal a boon to the mega-rich and fiscal suicide in a time of budget deficits, a Social Security and Medicare crisis, and war. The confusing reality is that there is statistical evidence can support both sides…and you do remember what Mark Twain said about statistics right?

One thing is certain: The uncertainty of our current estate tax is a burden on Americans and their financial planning which must re-evaluate estate planning options every year. For many on both sides of the issue, sensible reform is a preferable alternative to the success or failure of permanent repeal.

Outlook
In 2007, the Democrats regained power in Congress after 12 years of Republican control. The new Congress has been pursuing a fresh agenda and temporarily set estate tax relief on the back burner. When the issue does resurface, it’s likely that Congress will support reform over full and permanent repeal. Reforms such as lowering the estate tax rates to match capital gains tax rates and/or increasing the exemption amount have been proposed. Other options that have been discussed include doubling the exemption amount for married taxpayers, phasing out the tax over a five- or ten-year period, and replacing the estate tax with an inheritance tax (which would essentially shift the tax burden to the heirs). It remains to be seen what will be done, if anything.

Beyond 401(k)s and IRAs: Enjoy Your Life Today

You’re contributing the maximum to a 401(k) and also maxing out your Roth or traditional IRA. But, as a master spendthrift, you still have additional dollars you could save to ensure your retirement is everything you hope for. What options do you have?

Make Sure You Have a Life Today
Aggressive saving is a habit that all financially responsible people share. But don’t get carried away. Even though you’ll want a fulfilling retirement in 2050, don’t neglect your quality of life today. While you’re young, remember to also spend money on current experiences with others: fulfilling hobbies, international travels, and group outdoor adventures should be at the top of your list.

Besides, if you’re responsible enough to max out a 401k and a Roth IRA, then you probably also have a pile of cash sitting quietly in a savings account. You’ve setup an emergency fund already and are now looking for additional ways to put your dollars to work. If this is your situation, then trust us, you can afford to indulge yourself in a hot-air-balloon ride, a week in Spain, or a few days at the spa.

And after all of that, if you’ve still got some cash left over (lucky you!), then here are some other ways to set aside long-term dollars for retirement.

Are You Really Maxing Out Your 401(k) and IRA?
IRAs and 401(k)s have real advantages when it comes to saving for retirement. So, before you go any further, make sure you’re really contributing all you can.

In 2007, most individuals can contribute up to $15,500 to a 401(k) plan, and up to $4,000 to a traditional or Roth IRA. What’s more, if you file a joint tax return with your spouse, your spouse may be able to make a full IRA contribution, even if he or she has little or no taxable compensation.

Look at Deferred Annuities
If you are looking beyond 401(k)s and IRAs, one option you may be aware of is a deferred annuity. Deferred annuities are generally funded with after-tax dollars, but earnings are tax deferred, which means you don’t pay tax until you take a distribution from the annuity. There’s also no annual limit on contributions to an annuity.

The tax deferral offered by a deferred annuity is a nice feature, but it comes with some trade offs that you’ll need to weigh carefully:

• There are usually costly fees such as annual expenses, investment management fees, and insurance expenses
• A surrender charge may be imposed if you withdraw funds within a certain period of time
• A 10% federal penalty tax (in addition to any regular income tax) may apply if you withdraw funds from an annuity before age 59½
• Investment gains are taxed at ordinary income tax rates, not at lower capital gains rates

Annuities do have some unique benefits beyond tax deferral. With annuities, you can elect an annual payment amount that is guaranteed for the rest of your life (the guarantee is subject to the payment ability of the issuing institution)–this relative degree of certainty can be psychologically and financially comforting. In addition, annuities may offer some creditor protection under state law.

Taxable Investment Accounts
Your other basic option is to invest through a taxable investment account. The lower federal income tax rates that apply to long-term capital gains and qualifying dividends go a long way toward taking the bite out of holding investments outside of a tax-advantaged retirement account like a 401(k) or IRA. And, a taxable investment account offers one enormous advantage: You gain a tremendous amount of flexibility. You can choose from a virtually unlimited selection of specific investments, and there’s no federal penalty for withdrawing funds before age 59½.

Investment options worth mentioning:

• Index mutual funds and exchange-traded funds (ETFs) trade infrequently and therefore tend to have low annual taxable distributions
• Tax-free municipal bonds and municipal bond funds generate income that is free from federal and/or state income tax

Remember the Big Picture
Your investment decisions should be based on your individual goals, time frame, risk tolerance, and investment knowledge. You should evaluate every investment decision with an eye toward how the investment will fit into your overall investment portfolio, and whether it will meet your general asset allocation needs. A financial professional can be invaluable in helping you evaluate your options.

Lifecycle Funds: Cruise Control for Your Investing Strategy

A central investing principle states that your portfolio’s asset allocation should depend upon your time horizon, which is the length of time remaining until you will need to cash in your portfolio’s assets. But how exactly you distribute your money between stocks, bonds, and cash? And how do risk tolerance and time frame affect your portfolio over time? And what if you want to totally avoid the hassle of ongoing rebalancing for your individual stocks, bonds, and mutual funds?

Set It and Forget It
A lifecycle fund–sometimes called a target fund–attempts to tailor your investing strategy to your time frame for a particular goal, such as retirement.

Let’s say you plan to retire in 2040. You might choose a fund with a target maturity date of 2040. Between now and then, the fund will gradually shift its asset allocation between stocks, bonds, and cash. The closer the target date, the more conservatively (less stocks, more bonds) the fund would invest. A lifecycle fund with a target maturity date of 2040 would be likely to have a higher percentage of its assets in stocks than a fund targeted at 2010.

Advantages of Lifecycle Funds
Asset allocation is critical to your long-term returns, but if the idea of regularly rebalancing your retirement portfolio prompts an anxiety attack, then a lifecycle fund can help you simplify the process. The automatic asset allocation of a lifecycle fund may give you a better chance of achieving a long-term goal than if you tried to go it alone without investing experience or good financial advice. (Note: Diversification alone does not guarantee a profit or insure against a loss.)

Disadvantages of Lifecycle Funds
If you have other investments outside of the lifecycle fund, you may need help from a financial professional to achieve an appropriate overall asset allocation for your portfolio. Additionally, a lifecycle fund does not consider your individual financial situation, including tax concerns.

Don’t Be Fooled By Look-Alikes
Just because a lifecycle fund targets a particular time frame doesn’t mean your choice is a slam dunk. Even if they have the same target maturity date, lifecycle funds from various companies may have different approaches to achieving their goals. Most take a “fund of funds” approach, investing in an assortment of stock or bond funds from the same fund family. However, the number of funds used can vary widely.

An aggressive allocation for one portfolio with a 2040 target date may have a significantly greater percentage of stocks than another. Another important difference among funds is the way asset allocations are shifted over time, particularly after the target date has been reached. Some reach their most conservative allocation at the target date and then keep those percentages static. Others continue to become more conservative after the target date is reached.

You Can Do It!
With lifecycle funds, it’s particularly important to take a long-term perspective. You do not want to jump in and out of the fund in response to daily market changes. Lifecycle funds’ objectives are long-term, and your short-term selling typically undercuts the overall strategy.

Check your assumptions
Just because a lifecycle fund has a certain target date doesn’t mean it’s necessarily the right choice for you. People are living longer, and you may need a more aggressive allocation to provide a sufficient nest egg. A qualified financial professional can help you estimate your needs and gauge what strategy is most likely to work best for you.

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