Ken Himmler.com

A nonqualified deferred compensation (NQDC) plan is an arrangement between an employer and one or more employees to defer the receipt of currently earned compensation. You might want to establish a NQDC plan to provide your employees with benefits in addition to those provided under your qualified retirement plan, or to provide benefits to particular employees without the expense of a qualified plan.

NQDC plans vs. qualified plans

A qualified plan, such as a profit-sharing plan or a 401(k) plan, can be a valuable employee benefit. A qualified plan provides you with an immediate income tax deduction for the amount of money you contribute to the plan for a particular year. Your employees aren't required to pay income tax on your contributions until those amounts are actually distributed from the plan. However, in order to receive this beneficial tax treatment, a qualified plan must comply with strict and complex ERISA and IRS rules, and the plan must generally cover a large percentage of your employees. In addition, qualified plans are subject to a number of limitations on contributions and benefits. These limitations have a particularly harsh effect on your highly paid executives.

In contrast, NQDC plans can be structured to provide the benefit of tax deferral while avoiding almost all of ERISA's burdensome requirements. There are no dollar limits that apply to NQDC plan benefits (although compensation must generally be reasonable in order to be deductible). And you can provide benefits to your highly compensated employees without having to provide similar benefits to your rank and file employees.

Funded vs. unfunded NQDC plans

NQDC plans fall into two broad categories–funded and unfunded. A NQDC plan is considered funded if you have irrevocably and unconditionally set aside assets with a third party (e.g., in a trust or escrow account) for the payment of NQDC plan benefits, and those assets are beyond the reach of both you and your creditors. In other words, if participants are guaranteed to receive their benefits under the NQDC plan, the plan is considered funded.

You might consider establishing a funded plan if your employees are concerned that their plan benefits might not be paid in the future due to a change in your financial condition, a change in control, or your change of heart. Because the assets in a funded plan are beyond your reach, and the reach of your creditors, these plans provide employees with maximum security that their benefits will eventually be paid. Funded plans are rare, though, because they provide only limited opportunity for tax deferral and may be subject to all of ERISA's requirements.

Unfunded plans are by far more common because they can provide the benefit of tax deferral while avoiding almost all of ERISA's requirements. With an unfunded plan, you don't formally set aside assets to pay plan benefits. Instead, you either pay plan benefits out of current cash flow ("pay-as-you-go") or you earmark property to pay plan benefits ("informal funding"), with the property remaining part of your general assets and subject to the claims of your general creditors. You can set up a trust ("rabbi trust") to hold plan assets, but those assets must remain subject to any claims of your bankruptcy and insolvency creditors. A rabbi trust can protect your employees against your change of heart or change in control, but not against a change in your financial condition leading to bankruptcy.

In order to achieve the dual goals of tax deferral and avoidance of ERISA, your NQDC plan must be both unfunded and maintained solely for a select group of management or highly compensated employees. These unfunded NQDC plans are commonly referred to as "top-hat" plans.

While there is no formal legal definition of a "select group of management or highly compensated employees," it generally means a small percentage of the employee population who are key management employees or who earn a salary substantially higher than that of other employees.

Income tax considerations

Generally you can't take a tax deduction for amounts you contribute to a NQDC plan until your participating employees are taxed on those contributions (which can be years after your contributions have been made to the plan).

Employees generally don't include your contributions to an unfunded NQDC plan, or plan earnings, in income until benefits payments are actually received from the NQDC plan. The taxation of funded NQDC plans is more complex. In general, your employees must include your contributions in taxable income as soon as they become nonforfeitable (i.e., as soon as they vest). The taxation of plan earnings depends on the structure of the plan; in some cases employees must include earnings in taxable income currently, and in some cases they aren't taxed until they're actually paid from the plan.

Who can adopt a NQDC plan?

NQDC plans are suitable only for regular (C) corporations. In S corporations or unincorporated entities (partnerships or proprietorships), business owners generally can't defer taxes on their shares of business income. However, S corporations and unincorporated businesses can adopt NQDC plans for regular employees who have no ownership in the business. NQDC plans are most suitable for employers that are financially sound and have a reasonable expectation of continuing profitable business operations in the future. In addition, since NQDC plans are more affordable to implement than qualified plans, they can be an attractive form of employee compensation for a growing business that has limited cash resources.

Types of plans

Because a NQDC plan is essentially a contract between you and your employee there are almost unlimited variations. Most common are deferral plans and supplemental executive retirement plans (also known as SERPs). In a deferral plan your employee defers the payment of current compensation (e.g., salary or bonus) to a future date. A SERP is typically designed to supplement your employee's qualified plan benefits (for example, by providing additional pension benefits).

How to implement a NQDC plan

An ERISA lawyer can guide you through the maze of legal and tax requirements, and draft the plan document. Often the board of directors or compensation committee must approve the plan. Your accountant or consulting actuary can help you decide how to finance the plan. If you choose an unfunded plan, almost all that ERISA requires is that you send a simple statement to the Department of Labor informing them of the existence of the plan, and the number of participants.

The term "stretch IRA" has become a popular way to refer to an IRA (either traditional or Roth) with provisions that make it easier to "stretch out" the time that funds can stay in your IRA after your death, even over several generations. It's not a special IRA, and there's nothing dramatic about this "stretch" language. Any IRA can include stretch provisions, but not all do.

Why is "stretching" important?
Earnings in an IRA grow tax deferred. Over time, this tax-deferred growth can help you accumulate significant retirement funds. If you're able to support yourself in retirement without the need to tap into your IRA, you may want to continue this tax-deferred growth for as long as possible. In fact, you may want your heirs to benefit–to the greatest extent possible–from this tax-deferred growth as well.But funds can't stay in your IRA forever. Required minimum distribution (RMD) rules will apply after your death (for traditional IRAs, minimum distributions are also required during your lifetime after you reach age 70½). (Note: The Worker, Retiree and Employer Recovery Act of 2008 waives required minimum distributions for the 2009 calendar year.)

The goal of a stretch IRA is to make sure your beneficiary can take distributions over the maximum period the RMD rules allow. You'll want to check your IRA custodial or trust agreement carefully to make sure that it contains the following important stretch provisions.

Key stretch provision #1
The RMD rules let your beneficiary take distributions from an inherited IRA over a fixed period of time, based on your beneficiary's life expectancy. For example, if your beneficiary is age 20 in the year following your death, he or she can take payments over 63 additional years (special rules apply to spousal beneficiaries).
As you can see, this rule can keep your IRA funds growing tax-deferred for a very long time. But even though the RMD rules allow your beneficiary to "stretch out" payments over his or her life expectancy, your particular IRA may not. For example, your IRA might require your beneficiary to take a lump-sum payment, or receive payments within five years after your death. Make sure your IRA contract lets your beneficiary take payments over his or her life expectancy.

Key stretch provision #2
But what happens if your beneficiary elects to take distributions over his or her life expectancy but dies a few years later, with funds still in the inherited IRA?
This is where the IRA language becomes crucial. If, as is commonly the case, the IRA language doesn't address what happens when your beneficiary dies, then the IRA balance is typically paid to your beneficiary's estate. However, IRA providers are increasingly allowing an original beneficiary to name a successor beneficiary. In this case, if your original beneficiary dies, the successor beneficiary "steps into the shoes" of your original beneficiary and can continue to take required minimum distributions over the original beneficiary's remaining distribution schedule.

What if your IRA doesn't stretch?
You can always transfer your funds to an IRA that contains the desired stretch language. In addition, upon your death, your beneficiary can transfer the IRA funds (in your name) directly to another IRA that has the appropriate language.

And if your spouse is your beneficiary, he or she can also roll over the IRA assets to his or her own IRA, or elect to treat your IRA as his or her own (if your spouse is your sole beneficiary). Because your spouse becomes the owner of your IRA funds, rather than a beneficiary, your spouse won't have to start taking distributions until he or she reaches age 70½. And your spouse can name a new beneficiary to continue receiving payments after your spouse dies.

A word of caution
While you might appreciate the value of tax-deferred growth, your beneficiary might prefer instant gratification. If so, there's little to prevent your beneficiary from simply taking a lump-sum distribution upon inheriting the IRA, rather than "stretching out" distributions over his or her life expectancy. It's possible, though, to name a trust as the beneficiary of your IRA to establish some control over how distributions will be taken after your death. Your financial professional can help you sort through your stretch IRA options.

Stretching your IRA–A case study
Jack dies at age 78 with an IRA worth $500,000. He had named his surviving spouse, 69-year-old Mary, as his sole beneficiary. Mary elects to roll over the funds to her own IRA. Mary names Susan, her 44-year-old daughter, as her beneficiary. At age 70½, Mary begins taking required minimum distributions over a period determined from the Uniform Lifetime Table. (Mary is allowed to recalculate her life expectancy each year.) At age 79, Mary dies and Susan begins taking required distributions over Susan's life expectancy–29.6 years (fixed in the year following Mary's death). Susan names Jon, her 30-year-old son, as her successor beneficiary. Susan dies at age 70 after receiving payments for 16 years, and Jon continues receiving required distributions over Susan's remaining life expectancy (13.6 years). (See assumptions below.)
 

Assumptions:
• The rate of return on the underlying investments is a constant 6%, although the underlying securities in the account may involve risks that cannot be predicted
• All earnings are reinvested, and distributions are taken at year-end
• The projected figures assume that Mary takes the smallest distribution she's allowed to take under IRS rules at the latest possible time without penalty
• The projected figures assume that tax law and IRS rules will remain constant throughout the life of the IRA
• The projected figures do not take inflation into consideration

When it comes to planning for your retirement income, it's easy to overlook some of the common factors that can affect how much you'll have available to spend. If you don't consider how your retirement income can be impacted by investment risk, inflation risk, catastrophic illness or long-term care, and taxes, you may not be able to enjoy the retirement you envision. 

Investment Risk

Different types of investments carry with them different risks. Sound retirement income planning involves understanding these risks and how they can influence your available income in retirement.

Investment or market risk is the risk that fluctuations in the securities market may result in the reduction and/or depletion of the value of your retirement savings. If you need to withdraw from your investments to supplement your retirement income, two important factors in determining how long your investments will last are the amount of the withdrawals you take and the growth and/or earnings your investments experience. You might base the anticipated rate of return of your investments on the presumption that market fluctuations will average out over time, and estimate how long your savings will last based on an anticipated, average rate of return.

Unfortunately, the market doesn't always generate positive returns. Sometimes there are periods lasting for a few years or longer when the market provides negative returns. During these periods, constant withdrawals from your savings combined with prolonged negative market returns can result in the depletion of your savings far sooner than planned.

Reinvestment risk is the risk that proceeds available for reinvestment must be reinvested at an interest rate that's lower than the rate of the instrument that generated the proceeds. This could mean that you have to reinvest at a lower rate of return, or take on additional risk to achieve the same level of return. This type of risk is often associated with fixed interest savings instruments such as bonds or bank certificates of deposit. When the instrument matures, comparable instruments may not be paying the same return or a better return as the matured investment.

Interest rate risk occurs when interest rates rise and the prices of some existing investments drop. For example, during periods of rising interest rates, newer bond issues will likely yield higher coupon rates than older bonds issued during periods of lower interest rates, thus decreasing the market value of the older bonds. You also might see the market value of some stocks and mutual funds drop due to interest rate hikes because some investors will shift their money from these stocks and mutual funds to lower-risk fixed investments paying higher interest rates compared to prior years. 

Inflation risk

Inflation is the risk that the purchasing power of a dollar will decline over time, due to the rising cost of goods and services. If inflation runs at its historical average of about 3%, the purchasing power of a given sum of money will be cut in half in 23 years. If it jumps to 4%, the purchasing power is cut in half in 18 years.

A simple example illustrates the impact of inflation on retirement income. Assuming a consistent annual inflation rate of 3%, and excluding taxes and investment returns in general, if $50,000 satisfies your retirement income needs this year, you'll need $51,500 of income next year to meet the same income needs. In 10 years, you'll need about $67,195 to equal the purchasing power of $50,000 this year. Therefore, to outpace inflation, you should try to have some strategy in place that allows your income stream to grow throughout retirement.

Long-term expenses

Long-term care may be needed when physical or mental disabilities impair your capacity to perform everyday basic tasks. As life expectancies increase, so does the potential need for long-term care. And the cost of care is growing at a rate faster than inflation. (Source: The National Clearinghouse for Long-Term Care Information, 2008)

Paying for long-term care can have a significant impact on retirement income and savings, especially for the healthy spouse. While not everyone needs long-term care during their lives, ignoring the possibility of such care and failing to plan for it can leave you or your spouse with little or no income or savings if such care is needed. Even if you decide to buy long-term care insurance, don't forget to factor the premium cost into your retirement income needs.

The costs of catastrophic care

As the number of employers providing retirement health-care benefits dwindles and the cost of medical care continues to spiral upward, planning for catastrophic health-care costs in retirement is becoming more important. If you recently retired from a job that provided health insurance, you may not fully appreciate how much health care really costs.

Despite the availability of Medicare coverage, you'll likely have to pay for additional health-related expenses out-of-pocket. You may have to pay the rising premium costs of Medicare optional Part B coverage (which helps pay for outpatient services) and/or Part D prescription drug coverage. You may also want to buy supplemental Medigap insurance, which is used to pay Medicare deductibles and co-payments and to provide protection against catastrophic expenses that either exceed Medicare benefits or are not covered by Medicare at all. Otherwise, you may need to cover Medicare deductibles, co-payments, and other costs out-of-pocket. 

Taxes

The effect of taxes on your retirement savings and income is an often overlooked but significant aspect of retirement income planning. Taxes can eat into your income, significantly reducing the amount you have available to spend in retirement.

It's important to understand how your investments are taxed. Some income, like interest, is taxed at ordinary income tax rates. Other income, like long-term capital gains and qualifying dividends, currently benefit from special–generally lower–maximum tax rates. Some specific investments, like certain municipal bonds, generate income that is exempt from federal income tax altogether. You should understand how the income generated by your investments is taxed, so that you can factor the tax into your overall projection.

Taxes can impact your available retirement income, especially if a significant portion of your savings and/or income comes from tax-qualified accounts such as pensions, 401(k)s, and traditional IRAs, since most, if not all, of the income from these accounts is subject to income taxes. Understanding the tax consequences of these investments is vital when making retirement income projections.

Have you planned for these factors?

When planning for your retirement, consider these common factors that can affect your income and savings. While many of these same issues can affect your income during your working years, you may not notice their influence because you're not depending on your savings as a major source of income. However, investment risk, inflation, taxes, and health-related expenses can greatly affect your retirement income.

Mutual funds have been, and continue to be, a good solution for many investors seeking professional money management. But when you buy shares of a mutual fund, your assets are pooled with those of other fund shareholders. You gain professional money management, but the fund's manager certainly can't tailor its portfolio to meet your individual requirements.

For investors who want or need a more customized approach–for example, in order to better manage their tax liability or control individual stock holdings–separately managed accounts (SMAs) have become popular. Historically used by institutional investors and high-net-worth individuals, SMAs are now available to a wider group of investors as an alternative to mutual funds, though SMAs typically still require a higher minimum investment than a mutual fund might.

What is an SMA?

An SMA is a personal investment account that is customized and managed for you by one or more professional money managers. In an SMA, your assets are not commingled with those of other investors. With a mutual fund, you buy and sell shares of the fund. Even though each fund share represents a proportionate ownership of individual securities within the fund, your share of each of those securities is tiny. By contrast, you are the sole owner of each security within your separately managed account. You also can place securities you already own in an SMA; with mutual funds, you can't. As a result, you and your financial professional have more control over management of specific investments in an SMA.

Why is that control important? It increases your ability to coordinate the sale of specific securities with the rest of your overall financial plan.  It was once common for SMA programs to require a minimum of $1 million in investable assets, but today you can find separately managed accounts with minimums as low as $50,000. SMAs' lower minimums, along with a growing appreciation of their unique features, have led to their increasing popularity.

Is an SMA the same thing as a wrap account?

Both wrap accounts and SMAs charge fees based on the size of assets in the account, and the terms often are used interchangeably. However, with a wrap account, your financial professional may serve as the account's money manager, selecting individual securities or mutual funds for your portfolio. With an SMA, your financial professional may rely on a separate money manager (or multiple managers) to handle the day-to-day management of the portfolio or specific components of it. For example, with an SMA, you may be able to have a money manager who specializes in bonds manage that portion of the portfolio, while another manager who specializes in stock handles the equity portion. An SMA must be managed by a registered investment advisor, who may be independent or part of the same firm as your financial professional.

How SMAs trump mutual funds on taxes

Mutual funds have an inherent lack of tax efficiency. When you buy shares of a mutual fund, you automatically get a share of its embedded tax liabilities. By law, mutual funds are required to pay out realized capital gains to all fund holders, regardless of how long you have held its shares.

For example, if you buy shares in a mutual fund right before a distribution date, you may receive a distribution and have to pay capital gains taxes  even though you may have held the fund for only a short amount of time. The lack of tax efficiency can be a greater problem for actively managed mutual funds that buy and sell securities frequently than it is for indexed mutual funds.

Also, some fund investors can find themselves owing income tax on their fund investment, even though the fund may have declined in value during the year. If a fund manager sells some of a fund's holdings at a profit but other holdings drop in value, the fund can have a capital gains distribution even though its overall net asset value is lower.

By contrast, each security held in an SMA has an individual cost basis. That allows you to make specific tax-motivated moves. For example, you can generally request that your manager sell a position with an unrealized loss in order to offset capital gains, thus reducing your income tax liability.

Example: You sold a vacation home at a profit, but do not qualify for any exclusion. As a result, you owe capital gains taxes on that gain. To reduce your tax liability, you instruct your SMA manager to sell part of your position in a stock that has dropped in value. The manager sells enough stock to ensure that the losses on it offset any capital gains taxes you would owe as a result of the real estate sale.

How SMAs compare with mutual funds on trading costs, fees, and performance

Unlike traditional brokerage accounts, which are commission-based, SMA fee structures are asset-based. They typically cover the investment management fee, trading costs, custody, reporting, and financial planning services.

One thing to consider when comparing mutual fund expenses against SMA fees is the "invisible" trading costs incurred by mutual funds. Mutual fund expense ratios cover fund management fees, administrative costs, and other operating expenses. However, they don't cover trading costs, which include brokerage commissions whenever the fund buys or sells securities. Although these trading costs can vary significantly by mutual fund (depending in large part on their annual turnover rates), estimates of these costs range anywhere from .5% to 1%.

Also, mutual funds often carry a certain amount of cash as a cushion in case they experience a wave of redemptions from investors. That cash can act as a drag on performance. If a fund has to sell securities to meet redemption demands, that also can affect its results. Though an SMA involves its own risks and doesn't automatically guarantee you'll have better returns, you don't have to worry about the impact of other investors' actions, because an SMA has no other investors.

Because of the different ways in which fees for mutual funds and separately managed accounts are calculated, it can be challenging to compare those fees. Generally speaking, the larger your account, the more likely you are to benefit from an SMA. Before investing, ask your financial professional to do an "apples to apples" comparison between SMAs and mutual funds, including total fees and trading costs, to determine which is the better deal in terms of overall costs.

How SMAs can be customized for your specific situation

Another important feature of SMAs is their ability to allow you to exclude certain securities. You also can set sector guidelines to avoid investing in a sector you might disapprove of (for example, tobacco or casino stocks). This flexibility allows you to better tailor your asset allocation for your own unique circumstances and desires–key considerations for many investors with concentrated stock positions.

Example: You work for a large company that is a mainstay of most large-cap stock indexes, and you also hold shares in the company as a result of having exercised stock options. You instruct your SMA's manager not to buy your company's stock, to prevent your net worth being too dependent on one company.

However, don't expect to micromanage every single trade, as you might with a traditional brokerage account. Within the guidelines you set, the money manager typically will have discretion to implement strategies that he or she feels will provide the best returns for you. (After all, if you want to make all the decisions yourself, it probably doesn't make sense to hire a professional money manager.) However, you still have a great deal of flexibility to integrate those decisions with the rest of your financial concerns. And you'll always be able to track what has been bought and sold on your behalf.

The bottom line

For investors who place a priority on control and tax efficiency, and have the necessary capital, an SMA program may make a lot of sense. Your financial professional can help you crunch the numbers, look at your overall financial picture, and determine if an SMA might be right for you.

It wasn't so long ago that many investors regarded dividends as roughly the financial equivalent of a record turntable at a gathering of MP3 users–a throwback to an earlier era, irrelevant to the real action. But fast-forward a few years, and things look a little different. Since 2003, when the top federal income tax rate on qualified dividends was reduced to 15% from a maximum of 38.6%, dividends have acquired renewed respect. Favorable tax treatment isn't the only reason, either; the ability of dividends to provide income and potentially help mitigate market volatility is also attractive to investors. As baby boomers approach retirement and begin to focus on income-producing investments, the long-term demand for high-quality, reliable dividends is likely to increase.

Why consider dividends?

Dividend income has represented roughly one-third of the monthly total return on the Standard and Poor's 500 since 1926. According to S&P, the portion of total return attributable to dividends has ranged from a high of 53% during the 1940s–in other words, more than half that decade's return resulted from dividends–to a low of 14% during the 1990s, when investors tended to focus on growth. If dividends are reinvested, their impact over time becomes even more dramatic. S&P calculates that $1 invested in the Standard and Poor's 500 in December 1929 would have grown to $57 over the following 75 years. However, when coupled with reinvested dividends, that same $1 investment would have resulted in $1,353. (Bear in mind that past performance is no guarantee of future results, and taxes were not factored into the calculations.) If a stock's price rises 8% a year, even a 2.5% dividend yield can push its total return into the double- digit range.

Dividends can be especially attractive if the market is producing relatively low or mediocre returns; in some cases, dividends could help turn a negative return positive. Dividends also can help mitigate the impact of a volatile market by helping to even out a portfolio's return. Another argument has been made for paying attention to dividends as a reliable indicator of a company's financial health. Investors have become more conscious in recent years of the value of dependable data as a basis for investment decisions, and dividend payments aren't easily restated or massaged. Finally, many dividend-paying stocks represent large, established companies that may have significant resources to weather an economic downturn–which could be helpful if you're relying on those dividends to help pay living expenses. The corporate incentive Financial and utility companies have been traditional mainstays for investors interested in dividends, but other sectors of the market also have begun to offer them. For example, investors have been stepping up pressure on cash-rich technology companies to distribute at least some of their profits as dividends rather than reinvesting all of that money to fuel growth. Some investors believe that pressure to maintain or increase dividends imposes a certain fiscal discipline on companies that might otherwise be tempted to use the cash to make ill-considered acquisitions (though there are certainly no guarantees that a company won't do so anyway).

However, according to S&P, corporations are beginning to favor stock buybacks rather than dividend increases as a way to reward shareholders. If it continues, that trend could make ever-increasing dividends more elusive. Dividends paid on common stock are by no means guaranteed; a company's board of directors can decide to reduce or even eliminate them. However, a steady and increasing dividend is generally regarded as one sign of a company's ongoing health and stability. For that reason, most corporate boards are reluctant to send negative signals by cutting dividends. That isn't an issue for holders of preferred stocks, which offer a fixed rate of return paid out as dividends. However, there's a tradeoff for that greater certainty; preferred shareholders do not participate in any company growth as fully as common shareholders do. If the company does well and increases its dividend, preferred stockholders still receive the same payments.

The term "preferred" refers to several ways in which preferred stocks have favored status. First, dividends on preferred stock are paid before the common stockholders can be paid a dividend. Most preferred stockholders do not have voting rights in the company, but their claims on the company's assets will be satisfied before those of common stockholders if the company experiences financial difficulties. Also, preferred shares usually pay a higher rate of income than common shares. Because of their fixed dividends, preferred stocks behave somewhat similarly to bonds; for example, their market value can be affected by changing interest rates. And almost all preferred stocks have a provision that allows the company to call in its preferred shares at a set time or at a predetermined future date, much as it might a callable bond.

Look before you leap

Investing in dividend-paying stocks isn't as simple as just picking the highest yield. If you're investing for income, consider whether the company's cash flow can sustain its dividend. Also, some companies choose to use corporate profits to buy back company shares. That may increase the value of existing shares, but it sometimes takes the place of instituting or raising dividends. If you're interested in a dividend-focused investing style, look for terms such as "equity income," "dividend income," or "growth and income." Also, some exchange-traded funds (ETFs) track an index comprised of dividend-paying stocks, or that is based on dividend yield. Be sure to check the prospectus for information about expenses, fees and potential risks, and consider them carefully before you invest. Taxes and dividends Some dividends, such as those paid by real estate investment trusts (REITs) and master limited partnerships, don't qualify for the 15% maximum tax rate, and a portion may be taxed as ordinary income. Also, the 15% maximum rate is scheduled to expire at the end of 2010, and there is no guarantee dividends will continue to receive favorable tax treatment.

The 15% rate applies to qualified dividends–those that come from a U.S. or qualified foreign corporation, one that you have held for more than 60 days during a 121-day period (60 days before and 61 days after the stock's ex-dividend date). Form 1099-DIV, which reports your annual dividend and interest income for tax accounting purposes, will indicate whether a dividend is qualified or not. Be aware that some so-called dividends actually are considered interest for tax purposes. These include dividends from deposits or share accounts at cooperative banks, credit unions, U.S. savings and loan or building and loan associations, federal savings and loan associations, and mutual savings banks.

As baby boomers retire, they begin to focus less on accumulating assets and more on how those assets can be converted into an ongoing stream of income. Distribution funds are one way to simplify that process.

Distribution funds are actively managed mutual funds that focus not on maximizing asset growth but on making regularly scheduled payments to investors. Distribution funds were primarily designed to give retirees an easy way to receive income. For example, early retirees might use one to provide income until they reach full retirement age. They also can be used to complement a pension or other income sources.

How distribution funds work

A distribution fund basically functions much like a systematic withdrawal plan. Its annual payout (either a percentage of assets or a specific dollar amount) is divided into equal payments that are scheduled to be made at regular intervals (typically monthly or quarterly).

As with so-called lifestyle or lifecycle funds, distribution funds typically are offered as part of a group. All funds in the group use a similar investing methodology, but each fund has a different payout target or distribution rate. For example, one fund in the group might offer a 3% annual payout. Another fund in the same group might target a 4% payout, and a third might aim for 6%.

One size doesn't fit all

Even though funds within a given series are consistent in their approach to income distribution, methods used by various families of distribution funds to generate returns and calculate payments vary widely. For example, one series might differentiate its funds based on the annual percentage each one distributes. Another group of funds might determine annual income levels and asset allocation based on how long each fund's portfolio is intended to last. The shorter a fund's time horizon, the higher the targeted annual payout.

Some distribution funds are managed so that all capital is exhausted by the end of a designated time period, generally getting more conservative as that end date gets closer. Others are designed to preserve capital and make payouts primarily from earnings; these typically have no time frame attached. Regardless of how the targeted payout rate is derived for a given fund series, it's based on what is considered a sustainable withdrawal rate given the fund's objectives, planned asset allocation, and time frame (if applicable). Also, in some cases, the amount of the payout is adjusted to keep pace with inflation.

A distribution fund's method of providing its targeted income is generally based on historical rates of return for various types of investments in both good and bad markets. Though past performance is no guarantee of future results and asset allocation alone can't guarantee a profit or prevent a loss, each fund's strategy is intended to minimize the impact of market fluctuations on its income payout. However, there is no guarantee a fund's payout will remain the same from year to year.

A distribution fund is generally structured as a fund of funds, meaning that it is comprised of other mutual funds. However, some also include other types of investments.

Distribution funds aren't annuities

Because of their focus on income, distribution funds are designed to fill a role in retirement that is somewhat similar to that of annuity payments. However, there are some key differences between the two. Perhaps the most important is that distribution funds offer no guarantees of the payout levels they offer; annuities generally do (subject to the claims-paying ability of the annuity's issuer). Also, a mutual fund is not an insurance contract, as an annuity is. And annuities often are designed to ensure an income that lasts throughout an individual's lifetime, and/or that of a spouse. Though an investor can attempt to provide that by selecting an appropriate distribution fund, no fund can guarantee income for life.

Advantages of distribution funds

A distribution fund can simplify and streamline the process of receiving ongoing income. You don't have to worry about constructing that diversified portfolio yourself, shifting its asset allocation over time, or rebalancing it periodically. Also, the concept of a distribution fund may be easier to understand than an insurance contract that has many riders and variables. In addition, a targeted payout rate may make it easier to estimate how long your savings will last than if you were to try to manage your portfolio on your own.

Distribution funds also offer a great deal of flexibility. Even though you receive regularly scheduled payments, you can withdraw additional amounts from your principal at any time. That means you can adjust your annual retirement income from year to year, or make withdrawals to take care of unexpected costs. Investments that guarantee a regular income stream typically restrict the use of your principal.

Because distribution funds were intended as low-cost alternatives to annuities, expense ratios tend to be comparatively low.

Tradeoffs with distribution funds

As mentioned previously, a distribution fund may strive to provide a certain level of income, but there are no guarantees that it will do so. Depending on how a fund is structured and managed, a steep or prolonged market decline could affect the amount of the scheduled payments from year to year, or how long your investment will last. If you cannot afford either possibility, a distribution fund may mean more uncertainty–either long term or short term–than you're comfortable with.

If you are willing and able to structure and administer a systematic withdrawal program independently, you may be able to replicate many of the advantages of a distribution fund with a well-diversified portfolio. That would give you greater ability to customize payouts to your individual situation. For example, you could shift investments based on what's happening in the financial markets or your own life, and manage your tax situation from year to year.

Distribution funds are designed for individuals who plan to stay invested in a given fund for an extended period of time. If you're an active trader or might withdraw your money relatively quickly, you may want to think twice; in-and-out investing will undercut the very reason for choosing a distribution fund. And be aware that even though you can withdraw amountsover and above your scheduled payments, those withdrawals will reduce future earnings that would have supported distributions in later years. That could leave you vulnerable to longevity risk–the possibility of outlasting your savings.

You also may need to consider any projected distribution fund payouts in the context of other retirement income concerns, such as the tax consequences of those payouts, or required minimum distributions from a qualified retirement plan or IRA.

One of many choices

As you can see, there are many factors to think about. Review a fund's prospectus before investing so you can carefully consider how it's managed, its investment objectives, and the risks and costs involved. As with most investment options, a distribution fund may not fill all your retirement income needs. Don't hesitate to get expert advice on whether one might be useful for part of your portfolio, or for a specific purpose.

Investment planning during retirement is not the same as investing for retirement and, in many ways, is more complicated. Your working years are your saving years. With luck, your income increases from year to year as you receive promotions and/or pay raises; those increases offer some protection against rising costs caused by inflation. While you're working, your retirement objective generally is to grow retirement savings as much as possible, and investments that offer higher potential reward in exchange for greater potential for volatility and/or loss are often the focus for those retirement savings.

When you retire, on the other hand, spending rather than saving becomes your focus. Your sources of income may include Social Security, employer pensions, personal savings and assets, and perhaps some income from working part-time. Typically, a retiree's objective is to derive sufficient income to maintain a chosen lifestyle and to make assets last as long as necessary. This can be a tricky balancing act. Uncertainty abounds–you don't know how long you'll live or whether rates of return will meet your expectations. If your income is fixed, inflation could erode its purchasing power over time, which may cause you to invade principal to meet day-to-day expenses. Or, your retirement plan may require that you make minimum withdrawals in excess of your needs, depleting your resources and triggering taxes unnecessarily. Further, your ability to tolerate risk is lessened–you have less time to recover from losses, and you may feel less secure about your finances in general.

How, then, should you manage your investments during retirement given the above complications? The answer is different for everyone. You should tailor your plans to your own unique circumstances, and you may want to consult a financial planning professional for advice. The following discusses two important factors you should consider: (1) withdrawing income from retirement assets, and (2) balancing safety with growth.

Choosing a sustainable withdrawal rate
A key factor that determines whether your assets will last for your entire lifetime is the rate at which you withdraw funds. The more you withdraw, the greater the likelihood you'll exhaust your resources too soon. On the other hand, if you withdraw too little, you may have to struggle to meet expenses; also, you could end up with assets in your estate, part of which may go to the government in taxes. It is vital that you estimate an appropriate withdrawal rate for your circumstances, and determine whether you should adjust your lifestyle and/or estate plan.

Your withdrawal rate is typically expressed as a percentage of your overall assets, even though withdrawals may represent earnings, principal, or some combination of the two. For example, if you have $700,000 in assets and decide a 4 percent withdrawal rate is appropriate, the portfolio would need to earn $28,000 a year if you intend to withdraw only earnings; alternatively, you might set it up to earn $14,000 in interest and take the remaining $14,000 from the principal. An appropriate and sustainable withdrawal rate depends on many factors including the value of your current assets, your expected rate of return, your life expectancy, your risk tolerance, whether you adjust for inflation, how much your expenses are expected to be, and whether you want some assets left over for your heirs. Fortunately, you don't have to make a wild guess. Studies have tackled this issue, resulting in the creation of tables and calculators that can provide you with a range of rates that have some probability of success. However, you'll probably need some expert help to ensure that this important decision is made carefully.

Withdrawing first from taxable, tax-deferred, or tax-free accounts
Many retirees have assets in various types of accounts–taxable, tax-deferred (e.g., traditional IRAs), and tax-free (e.g., Roth IRAs). Given a choice, which type of account should you withdraw from first? The answer–it depends. Caution: Roth IRA earnings are generally free from federal income tax if certain conditions are met, but may not be free from state income tax.

Retirees who will not have an estate
For retirees who do not intend to leave assets to beneficiaries, the answer is simple in theory: Withdraw money from a taxable account first, then a tax-deferred account, and lastly, a tax-free account. This will provide for the greatest growth potential due to the power of compounding. In practice, however, your choices, to some extent, may be directed by tax rules. Retirement accounts, other than Roth IRAs, have minimum withdrawal requirements. In general, you must begin withdrawing from these accounts by April 1 of the year following the year you turn age 70½. Failure to do so can result in a 50 percent excise tax imposed on the amount by which the required minimum distribution exceeds the distribution you actually take.

Retirees who will have an estate
For retirees who intend to leave assets to beneficiaries, the analysis is more complicated. You need to coordinate your retirement plan with your estate plan.
If you have appreciated or rapidly appreciating assets, it may be more advantageous for you to withdraw from tax-deferred and tax-free accounts first. This is because these accounts will not receive a step-up in basis at your death, as many of your other assets will, and your heirs could face a larger than necessary tax liability.
Example(s): John is a widower with two children who retires at age 65. He has a tax-deferred pension plan valued at $200,000 and an investment portfolio holding appreciated shares of stock and bonds with a current value of $500,000 and a basis of $250,000. John's investment portfolio has been held long-term. Assume John is in the 15 percent tax bracket and his children are in the 33 percent tax bracket. Assume John's investment portfolio earns $25,000 each year, and assume no other variables. Say John dies four years later having made withdrawals totaling $100,000.

If John had withdrawn from his investment portfolio first, he would have paid $15,000 in federal ordinary income tax. His children would receive the $200,000 pension, on which they will have to pay federal ordinary income tax of $66,000. They would also receive the investment portfolio, which would receive a step-up in basis. Say the children sell the investment portfolio for $500,000 and owed no capital gains tax. In this scenario, the family (John and his children combined) pays $81,000 in federal taxes.

If John had withdrawn from his tax-deferred pension first, he would have paid $15,000 in federal ordinary income tax. His children would receive the $100,000 balance of the pension on which they would have to pay federal ordinary income tax of $33,000. They would also receive the $500,000 investment portfolio, which would receive a step-up in basis. Say the children sell the investment portfolio for $500,000 and owed no capital gains tax. In this scenario, the family (John and his children combined) pays $48,000 in federal taxes, $33,000 less than in the first scenario.

Caution: The example above is for illustrative purposes only and does not represent the performance of any investment. However, this may not always be the best strategy. For example, if you intend to leave your entire estate to your spouse, it may be better to withdraw from taxable accounts first. This is because spouses are given preferential tax treatment with regard to retirement plans. As a beneficiary of a traditional IRA or retirement plan, a surviving spouse can roll over retirement plan funds to his or her own IRA or retirement plan, or, in some cases, may continue the deceased spouse's plan as his or her own. The funds in the plan continue to grow tax deferred, and distributions need not begin until the spouse's own required beginning date. For retirees who have a "stretch" IRA, you may want to take advantage of your ability to defer taxes over a number of generations. Tip: Retirees in this situation should consult a qualified estate planning attorney who has some expertise with regard to retirement plan assets.

Balancing safety and growth
When you retire, you generally stop receiving income from wages, a salary, or other work-related activity and start relying on your assets for income. To ensure a consistent and reliable flow of income for your lifetime, you must provide some safety for your principal. This is why retirees typically shift at least a portion of their investment portfolio to more secure income-producing investments, and this makes a great deal of sense.

Unfortunately, safety comes with a price–reduced growth potential and erosion of value due to inflation. Safety at the expense of growth can be a critical mistake for some retirees. On the other hand, if you invest too heavily in growth investments, your risk is heightened, and you may be forced to sell during a downturn in the market should you need more income. Retirees must find a way to strike a reasonable balance between safety and growth.

One solution may be the "two bucket" approach. To implement this, you would determine your sustainable withdrawal rate (see above), and then reallocate a portion of your portfolio to fixed income investments (e.g., certificates of deposit and bonds) that will provide you with sufficient income for a predetermined number of years. You would then reallocate the balance of your portfolio to growth investments (e.g., stocks) that you can use to replenish that income "bucket" over time. The fixed income portion of your portfolio should be able to provide you with enough income (together with any other income you may receive, such as Social Security and required minimum distributions from retirement plans) to meet your expenses so you won't have to liquidate investments in the growth portion of your portfolio at a time when they may be down. This can help you ride out fluctuations in the market, and sell only when you think a sale is advantageous.

Be sure that your fixed income investments will provide you with income when you'll need it. One way to accomplish this is by laddering. For example, if you're investing in bonds, instead of investing the entire amount in one issue that matures on a certain date, spread your investment over several issues with staggered maturity dates (e.g., one year, two years, three years). As each bond matures, reinvest the principal to maintain the pattern.

As for the growth portion of your investment portfolio, common investing principles still apply:

•   Diversify your holdings
•   Invest on a tax-deferred or tax-free basis if possible
•   Monitor your portfolio and reallocate assets when appropriate

Caution: For retirees investing in bonds, don't assume that individual bonds and bond funds are the same type of investment. Bond funds do not offer the two key characteristics offered by bonds: (1) income from bond funds is not fixed–dividends change depending on the bonds the funds has bought and sold as well as the prevailing interest rate, and (2) a bond fund does not have an obligation to return principal to you when bonds within the fund mature. Additionally, the risk associated with bond funds varies depending on the bonds held within the fund at any given time, whereas the risk associated with individual bonds generally decreases over time as a bond nears its maturity date (assuming the issuer's financial situation doesn't deteriorate). Finally, fees and charges associated with bond funds reduce returns. Even so, you may still find bond funds attractive because of their convenience. Just be sure you understand the differences between bond funds and individual bonds before you invest.

A fixed annuity is a contract between you and an annuity issuer, usually an insurance company. In its simplest form, you pay money to the annuity issuer; the issuer invests the funds and pays the principal and its earnings back to you or to your named beneficiary. What's fixed about a fixed annuity? The issuer guarantees (subject to its claims-paying ability) a minimum rate of interest on your investment and a fixed benefit amount if you elect to annuitize.

When is an annuity appropriate?
Annuity contributions are made with after-tax dollars and are not tax deductible. That's why it's often advisable to fund other retirement plans first. However, if you've already contributed the maximum allowable amount to other plans and want to save more toward your retirement, an annuity can be an excellent choice. There's no limit to how much you can invest in an annuity, and the funds grow tax deferred until you begin taking distributions.

Once you begin withdrawing from your annuity, you'll pay taxes (at your regular income tax rate) only on the earnings, since your contributions to principal were made with after-tax dollars. Like a qualified retirement plan, a 10% tax penalty may be imposed if you withdraw from an annuity before age 59½.

Annuities are designed to be very-long-term investment vehicles. In most cases, if you take a withdrawal, including a lump-sum distribution of your annuity funds within the first few years after purchasing your annuity, you may be subject to surrender charges imposed by the issuer. However, many companies allow options for withdrawals or distributions without incurring a charge. As long as you're sure you won't need the money until at least age 59½ and you understand the costs (including fees) involved, an annuity is worth considering.

Two distinct phases to an annuity
There are two distinct phases to an annuity contract: the accumulation phase and the distribution phase. In the accumulation phase, you're putting money into the annuity. You can choose to pay your premiums in one lump sum, or you can make a series of payments over time. These payments can be of equal amounts made at equal intervals, or of variable amounts at irregular intervals, depending on the terms of the contract.

Annuities may be either immediate or deferred; the terms simply refer to when the distribution phase begins. Immediate annuities are typically purchased with a single payment and the distribution phase usually begins within a year of the purchase. While deferred annuities may be purchased with a single lump sum premium payment, they are most often purchased with a series of periodic payments. The distribution period is deferred until some time in the future.

In the distribution phase, you begin taking money out of the annuity. You may withdraw some or all of the money in lump sums, or you may annuitize. Subject to the claims-paying ability of the issuer, annuitization provides a guaranteed income stream for either a specified period or for life.

How a Fixed Deferred Annuity Works

1. In the accumulation phase, you (the annuity owner) send your premium payment(s) (all at once or over time) to the annuity issuer. These payments are made with after-tax funds, and you may invest an unlimited amount.
2. The annuity issuer places your funds in its general account.* Your annuity contract specifies how your principal will be returned as well as what rate(s) of interest you'll earn during the accumulation phase. Your contract will also state what minimum interest rate applies.**
3. The compounding interest on your annuity accumulates tax deferred. You won't be taxed on these earnings until funds are withdrawn or distributed.
4. The issuer may collect fees to manage your annuity account. You may also have to pay the issuer a surrender fee if you withdraw money in the early years of your annuity.
5. Your annuity contract may contain a guaranteed** death benefit or other provisions for a payout upon the death of the annuitant. (The annuitant provides the measuring life used to determine the amount of the payments if the annuity is annuitized. As the annuity owner, you're most often also the annuitant, although you don't have to be.)
6. If you make a withdrawal from your deferred annuity before you reach age 59½, you'll not only have to pay tax (at your ordinary income tax rate) on the earnings portion of the withdrawal, but you may also have to pay a 10 percent premature distribution tax, unless an exception applies.
7. After age 59½, you may make withdrawals from your annuity without incurring any premature distribution tax. Since annuities have no minimum distribution requirements, you don't have to make any withdrawals. You can let the account grow tax deferred for an indefinite period. However, your annuity contract may specify an age at which you must begin taking income payments.
8. To obtain a guaranteed** fixed income stream for life or for a certain number of years, you could annuitize which means exchanging the annuity's cash value for a series of periodic income payments. The amount of these payments will depend on a number of factors including the cash value of your account at the time of annuitization, the age(s) and gender(s) of the annuitant(s), and the payout option chosen. Usually, you can't change the payments once you've begun receiving them.
9. You'll have to pay taxes (at your ordinary income tax rate) on the earnings portion of any withdrawals or annuitization payments you receive.

* These funds are invested as part of the general assets of the issuer and are therefore subject to the claims of its creditors.
** All guarantees are subject to the claims-paying ability of the issuing company.