Ask Liz Weston

Get smart with your money

Investing

Q&A: Capital gains tax on mutual funds

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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

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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?

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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.

Answer: 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

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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

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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.

Q&A: Rolling 401(k) into an IRA

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Dear Liz: I’m leaving my job later this month and am trying to decide what to do with my 401(k) account. Some of my friends say to leave it where it is, and others say to roll it into a traditional individual retirement account or Roth IRA. Which is best?

Answer: You can’t roll a 401(k) directly into a Roth IRA. You would first need to roll it into a traditional IRA, then convert that to a Roth and pay the (often considerable) tax bill.

But let’s back up a bit. There are few reasons you might want to leave the money where it is, if you’re happy with your employer’s plan. Many large-company plans offer access to low-cost institutional funds that are cheaper than what you might find as a retail customer with an IRA.

Money in a 401(k) also has unlimited protection from creditors in case you’re ever sued or wind up filing for bankruptcy. When the money is in an IRA, the protection is typically limited to $1 million.

If you’re not happy with your old employer’s plan, you could transfer the account to your new employer’s plan if that’s allowed. If not, you can roll the 401(k) into an IRA, but choose your IRA provider carefully.

You’ll want access to a good array of low-cost mutual funds or exchange traded funds (ETFs). The costs you pay to invest make a huge difference in how much you eventually accumulate, so it’s important to keep those expenses down.

If you want help managing the money, many discount brokerages offer access to financial planners and some, including Vanguard and Charles Schwab, offer low-cost digital investment advice services. The services, also known as “robo-advisors,” use computer algorithms to invest and monitor your portfolio.

You’ll want to arrange a direct rollover, in which the money is transferred from your 401(k) account into the new IRA.

Avoid an indirect rollover, in which the 401(k) company sends a check to you. You would have 60 days to get the money into an IRA, but you’d have to come up with the cash to cover the 20% that’s withheld in such transfers. You would get that cash back when you file your taxes, but it’s an unnecessary hassle you can avoid with a direct rollover.

Before you decide to convert an IRA to a Roth, consult a tax professional.

Conversions can make sense if you expect to be in the same or higher tax bracket in retirement, which is often the case with young investors, and you can tap some account other than the IRA to pay the income taxes. But these can be complex calculations, so you should run your plan past an expert.