Ask Liz Weston

Dear Liz: I’m a financial planner who liked your answer to the dad who wanted to fund his children’s IRAs but was shocked to see your recommendation (though with caveats) to purchase annuities.

I can’t imagine annuities would be suitable for children under any circumstances. Only under the best possible scenario of assumptions would an investment in an annuity (even a low-cost annuity) beat a reasonably tax-efficient mutual fund over any time period.

As long as money withdrawn from an annuity remains taxable as ordinary income, and as long as ordinary income tax rates are measurably higher than capital gains rates, this will be the case. I fear that brokers will be handing out your article as a tool to sell annuities for kids. To get an endorsement from someone of your reputation has probably helped some of them make this week’s sales goals. Let’s hope not!

Answer: Let’s hope not, indeed. Annuities tend to have high costs and do just one thing efficiently: turn capital gains that would otherwise qualify for low tax rates into ordinary income, which is taxed at a much higher rate.

Most investors would, as you point out, be much better off investing in index funds or other tax-efficient mutual funds.

However, annuities have one advantage that might appeal to this dad: They’re typically not counted in financial aid formulas, according to FinAid.org founder Mark Kantrowitz, because they’re considered retirement accounts. If the children don’t have enough earned income to fund IRAs, annuities would allow him to start saving for their retirements without having to worry about reducing their future aid packages.

This advantage may not outweigh all the disadvantages of annuities. But it’s something the dad should know about as he’s mulling over his options.

Dear Liz: We have good credit with FICO scores in the 780 to 800 range. For most of the last 20 years we have paid all of our credit card bills in full and on time, never incurring any interest charges. Recently, though, we’ve started taking advantage of “buy now, pay nothing for a year” credit card offers.

Question: I have been steadily investing in stock mutual funds since my early 20s. I have been following the buy-and-hold strategy, and unfortunately I have not been rebalancing my portfolio. Consequently, the vast majority of my portfolio is invested in growth mutual funds that have appreciated in value over the years.

I am now approaching retirement and want to reduce my risk. Should I leave my portfolio as is and invest any new money into fixed-income securities, or should I sell some of my growth mutual funds, which will trigger a substantial capital gains tax?

Answer: It sounds as if you’ve done a good job investing for your future. Now, you need to call in some help.

An objective, experienced, fee-only financial planner could take a look at your total financial situation  including your age, life expectancy, risk tolerance, expenses and other sources of income  to construct a portfolio strategy that will guide you safely through your retirement years.

This really isn’t a do-it-yourself project. There are too many ways to mess up your retirement income stream and too few ways to fix any errors you make. Take too much risk or withdraw too much from your accounts, and you could run out of money. Take too little risk, and the same thing could happen.

You really want professional help. Two sources for referrals are the National Assn. of Personal Financial Advisors (www.napfa.org or by phone toll-free at [888] FEE-ONLY) and the Garrett Planning Network, http://www.garrettplanningnetwork.com ).

If your portfolio truly is overweighted with growth funds, the planner perhaps in consultation with a tax pro might have you gradually sell off some of those investments so you can diversify into bonds, cash, value funds and international investments.

 

The good news is that the top federal capital gains rate, 15%, is low, so you should still have plenty of money to reinvest.