Q&A: How to avoid hiring a Madoff-like financial advisor

Dear Liz: What is the best way to pick a financial advisor to make sure they don’t make off with all your retirement money? I don’t want Bernie Madoff handling my retirement savings.

Answer: Even if you turn over day-to-day investment decisions to an advisor, you should make sure your money is invested at an independent custodian such as a nationally known brokerage or mutual fund company. That won’t immunize you from fraud, but Ponzi schemes are a lot harder to pull off when there’s third-party oversight.

Returns that are too good to be true, investments that you don’t understand or pressure from an advisor to invest are other red flags for fraud.

Protecting yourself from fraud is important, but so is protecting yourself from bad or conflicted advice. You need to check out any advisor thoroughly. Ask about experience, credentials and other qualifications. Find out how they get paid. Fee-only advisors are compensated only by the fees their clients pay and don’t accept any commissions for recommending products. Fee-based advisors, by contrast, may accept fees and commissions.

Your advisor should be willing to sign a fiduciary oath to put your interests first. That’s not currently required. Advisors can put you in expensive or underperforming investments just because those options pay them higher commissions and there’s little legal recourse for investors unless they can prove that the investments were clearly unsuitable for their situation.

Starting next year, advisors will be held to a fiduciary standard when counseling clients about retirement funds. There’s no reason you should wait for that rule to kick in, though. You can download a copy of a fiduciary oath for your advisor to sign at www.thefiduciarystandard.org.

Q&A: How to get out from under high brokerage fees

Dear Liz: I have two accounts at a full-service brokerage. One is an inherited IRA and the other is a Roth IRA that I opened. Both have a mix of stocks and mutual funds that I chose. My accounts have done well, but I am not happy with the commissions that my brokerage charges when I trade, which I don’t do often. What do I have to do to move these accounts somewhere else that doesn’t charge such high commissions? I don’t want to sell the stocks and funds in the accounts, but to transfer them intact. If I had to sell the funds, I’d end up paying some of the fees that I’m trying to avoid.

Answer: As long as you don’t own any proprietary mutual funds in those accounts, you should be able to transfer the actual investments and your IRAs to another brokerage — just pick a discount brokerage this time. Those high commissions erode the amount you’ll have at retirement and aren’t necessary if you’re managing your own investments.

The new brokerage will be eager to help — just call and explain you want to transfer the assets “in kind.” You’ll be provided with the information and forms you need to start the process, and the new brokerage will take it from there.

Be prepared for one bite in the form of “account liquidation” fees. Many (but not all) investment firms charge these when you close IRAs, and they can range from $20 to $95 per account.

Q&A: Dealing with a big lottery win

Dear Liz: My brother-in-law won a good chunk of money playing the lottery. He is waiting for the check to come any day now. He is willing to give me $2 million. The question for you is how I can maximize that amount of money short term or long term?

Answer: If your brother-in-law has any sense at all, he’ll realize he shouldn’t have promised any gifts before he assembled a team of professional advisors. And they almost certainly will have a dim view of him giving you a seven-figure sum.

Handouts that large have gift tax consequences. Anything over the annual exemption amount, which this year is $14,000 per recipient, has to be reported on a gift tax return. Amounts over $14,000 count against his lifetime exemption limit, which is $5.45 million this year. Once that limit is exceeded, he’ll owe substantial tax on any gifts.

Also, the $5.45-million limit is for gift and estate taxes combined. Any part of the exemption he uses during his lifetime for gifts won’t be available to shield his estate from estate taxes when he dies. Although, given his apparent generosity, he may not have enough left at his death to trigger an estate tax.

It’s not uncommon for those who receive large windfalls to wind up broke, especially if the amount is much larger than they’re used to handling. More than a few professional athletes and lottery winners have wound up in bankruptcy court. They spend or give away money at a clip that simply isn’t sustainable.

Which may be the road down which your brother-in-law has started. You can take advantage of your relative’s ignorance by holding him to his pledge or you can do the right thing, which is to encourage him to hire fee-only advisors — including a CPA, an estate-planning attorney and a comprehensive financial planner who’s willing to sign a fiduciary oath — to help him deal with this windfall.

Q&A: Tips for divvying up your retirement investments

Dear Liz: With all the investment options offered in 401(k) plans, how as a contributor do I know where to place my money?

Answer: Too many investment options can confuse contributors and lower participation rates, according to a study by social psychologist Sheena Iyengar of Columbia University in cooperation with the Vanguard Center for Retirement Research. The more options, the more likely participants are to simply divide their money evenly among the choices, according to another study published in the Journal of Marketing Research. That’s a pretty random method of asset allocation and one that may not get people to their retirement goals.

As a participant, you want a low-cost, properly diversified portfolio of investments. For most people, that means a heavy weighting toward stock funds, including at least a dab of international stocks. Your human resources department or the investment company running the plan may be able to help with asset allocation.

Some plans offer free access to sophisticated software from Financial Engines or Morningstar that can help you pick among your available options. Once you have your target asset allocation, you’ll need to rebalance your portfolio, or return it to its original allocation, at least once a year. A good year for stocks could mean your portfolio is too heavily weighted with them, while a bad year means you need to stock up.

If that feels like too much work, you may have simpler options. Many plans provide a balanced fund, typically invested 60% in stocks and 40% in bonds, that provides automatic reallocation. The same is true for target-date funds, which are an increasingly popular choice. Pick the one with the date closest to your expected retirement year. If you’re 35, for example, you might opt for the Retirement 2045 fund.

It’s important, though, that you minimize costs because funds with high fees can leave you with significantly less money at retirement. The average target-date fund charged 0.73% last year. If you’re paying much more than that, and have access in your plan to lower-cost stock and bond funds, choose those instead.

Q&A: Saving and investing for a child

Dear Liz: I recently got a court judgment for my daughter’s father to pay me child support. She is 1 year old, and it will be about $1,500 a month. I would like this money to be a gift for her when she is older. I’m told not to put it in her name now, as it may hurt her chance for financial aid for college later. How do you recommend I save and invest it for her? I’d like her to have it when she is a young adult.

Answer: This could be quite a gift for a young woman. If the money earned a 5% average annual return over time, you could be presenting her with a check for half a million dollars.

Consider putting at least some of the money in a 529 college savings plan. Withdrawals from these plans are tax-free when used to pay qualified college expenses. College savings plans receive favorable treatment in financial aid formulas because they’re considered an asset of the contributor (typically the parent), rather than the child.

Q&A: Capital gains tax on mutual funds

Dear Liz: My mother, who is approaching 100 and in good health, has a significant mutual fund holding. It is mostly made up of capital gains. She does not need this fund for her daily living expenses. The question she has: Are the taxes on disposition the same before or after she dies? I am thinking of things like the capital gains tax exemption (never used) as well as inheritance taxes.

Answer: The capital gains tax exemption applies to the sale of a primary residence — a home, not a mutual fund. If your mother sold the fund today, she would owe capital gains tax on the difference between the sale price and her “cost basis.” Her cost basis is what she paid for the fund originally plus any reinvested dividends. The top federal capital gains tax rate is 20%, although most taxpayers pay a 15% rate.

If her objective is to get the maximum amount to her heirs and minimize the tax bill, she should bequeath this investment to them at her death. Then the mutual fund will get a “step up” in tax basis to the current market value. When the heirs sell the investment, they’ll only owe taxes on the appreciation that occurs after her death (if any).

You asked about inheritance taxes, but only a few states levy taxes on inheritors. Typically, it’s the estate that would pay the taxes, and only those above certain amounts. In 2016, the federal estate taxes exemption is $5.45 million

Q&A: Investment returns

Dear Liz: In a recent column you mentioned a fund that shows a return of 7% consistently for several years to present. Would you be so kind as to provide me with the name of the fund?

Answer: I don’t know of any mutual fund that’s shown a consistent 7% return year in and year out. What you may be referring to is research showing overall stock market returns. Taking into account each year’s gains and losses, the average annual return over each 30-year period starting in 1928 — from 1928 to 1958, 1929 to 1959, and so on — is greater than 8%, but you can’t expect 8% every year.

Q&A: Invest or pay down mortgage?

Dear Liz: I usually finish the month with $1,000 to $2,000 left over after expenses to invest. My savings are with a money manager who has conservatively invested in a diversified portfolio. Given the uncertainty of the market, does it make any sense for me to start using that monthly excess to pay down the balance on my 15-year mortgage rather than continue to invest? The mortgage has about 91/2 years to go with a balance of just under $75,000. One added point: I would like to retire in about five years.

It’s time to talk to a fee-only financial planner who can review your entire financial situation and offer personalized advice. The planner can give you a better idea if you’re really on track to retire within five years. If you are, then paying down the mortgage may be an excellent use of the money. Having a paid-off home will reduce your monthly expenses, which in turn can reduce how much of your retirement funds you’ll need to tap.

Before you prepay a mortgage, though, you should make sure all your other financial ducks are in a row. In addition to saving enough for retirement, you should have paid off all your other debt, accumulated a decent emergency fund (at least six months’ worth of expenses) and be properly insured.

Q&A: Using Roth IRA earnings for a first-time home purchase

Dear Liz: My 29-year-old son recently married, and as a gift I pledged $20,000 as a down payment on a house. My daughter-in-law is beginning a career as a registered nurse and I know they will not be buying for a few years. Is there any type of account that will grow tax-free or tax-deferred for a first-time buyer? Maybe I could gift this money to them into a retirement account for the time being?

Answer: You may be able to give them enough money to fund Roth IRA accounts for both 2015 and 2016. They would be able to withdraw those contributions tax- and penalty-free at any time in the future for whatever purpose they wanted.

Withdrawing earnings from a Roth can trigger taxes and penalties, but that’s not likely to be an issue in this case. Each person is allowed to withdraw up to $10,000 in Roth earnings for a first-time home purchase. If they plan to buy a home within a few years, it’s highly unlikely that your gift would generate enough earnings to cause concern.

The ability to contribute to a Roth begins to phase out for married couples filing jointly at modified adjusted gross income of $183,000 in 2015 and $184,000 in 2016. Assuming their incomes were below those limits, they each can contribute up to $5,500 per year to a Roth. The deadline for making 2015 contributions is April 15, 2016. If you give them the money now, they could fund two years’ worth of contributions at once.

Q&A: Brokerage accounts

Dear Liz: I have some questions regarding my brokerage accounts. What happens to my investments there if the brokerage company goes out of business? How much of my investments will I be able to recover and how? Also, does it matter if my accounts are IRAs, Roth IRAs, or conventional brokerage accounts?

Answer: Most brokerages are covered by the Securities Investment Protection Corp., which protects up to $500,000 per eligible account, which includes a $250,000 limit for cash.

Different types of accounts held by the same person can get the full amount of coverage. IRAs, Roth IRAs, individual brokerage accounts, joint brokerage accounts and custodial accounts could each have $500,000 of coverage.

So with an IRA, a Roth and a regular brokerage account, you would have up to $1.5 million in coverage.

If you have a few traditional IRAs at the brokerage, though — say, one to which you contributed and one that’s a rollover from a 401(k) — those two would be combined for insurance purposes and covered as one, with a $500,000 limit.

In addition to SIPC coverage, many brokerages buy additional insurance through insurers such as Lloyds of London to cover larger accounts.

It’s important to understand that SIPC doesn’t cover losses from market downturns. The coverage kicks in when a brokerage goes out of business and client funds are missing.

SIPC is commonly compared to the Federal Deposit Insurance Corp., which protects bank accounts, but there’s an important difference between the two.

The FDIC is backed by the full faith and credit of the U.S. government. SIPC has no such implicit promise that if it’s overwhelmed by claims, the government will come to the rescue.