Many of you, being responsible investors, have also been planning for the future. Hopefully you have established a retirement savings account such as an IRA or 401(k). After spending years contributing to these plans and investing wisely, many of you will have sizable accounts that you might leave one day to your heirs. You might also find yourself as the beneficiary of someone else’s plan. There are many important details concerning inheritance of these funds, especially in cases where the beneficiary is not a spouse of the account holder. Through careful planning you can ensure that these accounts continue to grow tax-deferred for many years beyond the death of the original account holder.

The first priority is to make certain that a beneficiary is detailed for each of your plans. Not having a beneficiary listed can preclude your estate from taking advantage of very favorable tax treatment. The beneficiary of an IRA must have a life-expectancy upon which to base minimum annual withdrawals. Without an actual person named, the entire account must be withdrawn, and taxes paid, within five years. (If the deceased had already started to take distribution, the original distribution plan could also stay in effect.)

Kevin Pollock is an attorney with a Masters in Taxation who focuses on estate planning. He stresses the importance of designating beneficiaries properly. “This ensures that your hard-earned money goes where you want it to go. The biggest mistake is made when simple names are used instead of making a formulaic allocation.”

An example of this is if you had two children, Joe (childless) and Jane (with two children of her own). If you list Joe and Jane as beneficiaries, each would receive half of your account. If Jane dies, Joe would receive everything. If your intention is for Jane’s two children to receive her share, your beneficiary designation must be written in such a formulaic way as to convey your true intent.

Even with new rules providing more favorable tax treatment to non-spousal beneficiaries, leaving your retirement accounts to your spouse is still the most simple and advantageous route to take for most people. The spouse can roll the fund over to his or her own IRA or a new IRA, continue to make contributions, and not have to withdrawal the funds until he or she reaches 70 ½.

Things get a little more complicated when you inherit an IRA from someone other than a spouse. The funds cannot be co-mingled with any IRAs you might already have. You must set up an Inherited or Beneficial IRA. It is extremely important that the account is named correctly. Mess up here and the tax consequences could be huge, as in having to pay taxes on the lump sum that year. Ouch! The name of both the deceased and the beneficiary must be on the account, with the more detail the better. An example; “Mary Jones (deceased 3/15/07) Inherited IRA for the benefit of Sally Smith, beneficiary.” It is very important that the transfer of funds be done properly. The check must be made out in the name of the deceased and sent to the institution that will house the Inherited IRA. If the check is made out to the beneficiary, it would be considered a lump sum distribution and taxes would be due. Again, ouch!

Now that the Inherited IRA has been established, the beneficiary must start taking minimum required distributions (MRD). Unlike spouses, who can wait until they reach age 70 ½ to begin withdrawals, the non-spousal heir must begin these distributions by December 31of the year following the account-holder’s death. The distribution will, however, be based on the life expectancy of the beneficiary, no longer the deceased. Younger heirs can withdraw the lower MRD, allowing the principal to continue to grow over their entire lifetime.

There is still the option of taking the lump-sum distribution instead of setting up the Inherited IRA. The funds would then be considered taxable income. This can result in a double-whammy of sorts, as the large sum of taxable money often bumps the beneficiary into a higher tax bracket as well.

A third option of the beneficiary is to give the funds away. This usually occurs when someone doesn’t need the money and they want their younger children to have the money. This is best arranged during the life of the account holder. The fund can be left to the spouse, with the children listed as contingent beneficiaries. If the spouse doesn’t need the money and refuses the bequest, it would then be inherited by the children, who would have to set up Inherited IRAs or take the lump sum. They would have an even longer life expectancy upon which to grow the account balance tax-deferred. There are many more details involved than there is room here, so make certain to consult a tax or estate planning specialist before attempting to set any of this up on your own.

The Pension Protection Act of 2006 provides similar treatment for the inheritance of 401(k)s by non-spouses by permitting your non-spousal heirs to transfer these assets to an IRA. One unforeseen problem is that the Act doesn’t mandate that companies provide this option. Some companies have opted not to make the necessary changes to their policies due to the time and expense it would take. Now is a good time, if you plan on leaving your 401(k) to someone other than your spouse, to check with your company and ensure that your beneficiaries will be allowed to move the funds to an Inherited IRA if they choose.

Some still recommend that you roll your 401(k) into an IRA of your own when you leave a company, which is permitted by all plans. Although the Pension Protection Act now provides better options for non-spousal beneficiaries of a 401(k), an IRA will give you greater investment options and ensure that your heirs can stretch the distributions over their lifetime. The possible negative is if you need to make use of these funds between ages 55 and 59 ½. Taking an early withdrawal from your 401(k) at these ages will not result in a penalty. If you’ve moved the funds into an IRA, you would have to pay a 10% early withdrawal penalty.

Bill Christensen, Vice President Investment Advisors with Fifth Third Bank, reminds us how timing can be critical. “You have until December 31 of the year after the death of the account-holder to create an Inherited IRA and begin taking MRDs. Miss this date and you’re back to a major tax hit, as well as the loss of future growth of those tax-deferred funds.” To preserve all of your inheritance options, it is best to make certain decisions within nine months of the death. The IRS does not take ignorance of the rules, or grief, as an excuse for missed deadlines.

Christensen also stresses that “the issue of retirement fund inheritance will continue to grow in importance. As firms move away from pensions and the uncertainty of social security looms in the future, more of an individual’s net worth will be tied up in IRAs and 401(k)s than in the past.”

Once again, the common recommendation is to consult a tax professional or estate planner not only before taking distributions from an inherited retirement account, but also while setting up your own plans. Make certain the individual is up-to-date on the ever-changing rules related to your qualified plan. There are so many possible mistakes that can be made, resulting in not only major tax consequences, but also the loss of valuable long-term earning potential for either you or your intended heirs.

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

John C. Bogle is founder, former chief executive and former chairman of Vanguard Group. Inc., one of the largest mutual fund groups in the world. He helped create the first index mutual fund in 1975. He is president of Bogle Finan­cial Markets Research Center in Malvern. Pennsylvania. In 2004, Time named Bogle one of the 100 “Most In­fluential People in the World,” and in 1999, Fortune named him one of four “investment giants of the 20th century.

For four decades, Vanguard founder John C. Bogle has been a hero to small investors. He also has been a gadfly to the mutual fund industry which, he says, too often charges fees that are too high while delivering lackluster performance. Bogle, 77, has remained active on mu­tual fund issues since he retired from Vanguard in 1999. He lobbied in Washington, DC. for tighter regulation of mutual fund advertising and recently authored his sixth book, The Little Book of Common Sense Investing (Wiley).

Bottom Line/Personal asked Bogle to expand on his recent warnings to inves­tors that danger signs surround the US economy and that investment returns will drop. He also discussed how inves­tors can prepare for the future…

How do you expect stocks to per­form in the next several years?

I predict annualized returns of 7% to 8% for the Standard & Poor’s 500 stock index over the next decade. 1 know that’s not what investors want to hear, and it’s cer­tainly not what stockbro­kers will tell them. But I base my predictions on the numbers, which I call the “relentless rule of humble arithmetic.”

Stock market returns are created by the growth of actual businesses. In the past century, those businesses have paid div­idends averaging 4.5% of stock prices, and their earnings have grown an average of 5% - a total of 9.5% per year. How­ever, since 1980. the S&P 500 - my proxy for the market - has provid­ed total returns of 12.5% a year. Those extra three percentage points each year reflect a premium in the price inves­tors were willing to pay for each dollar of earnings. That increase has kept returns artificially inflated for a long, long time. In effect, investors were convinced each year that the US economy would continue to do better and better.

Why can’t returns remain high for many years to come?

There are two basic reasons. First, even if companies continue to grow their earnings at the long-term average of 5% per year, their divi­dend yields - which are part of total returns - are nowhere near 4.5% now. In fact, they average less than 2%.

Second, the current price-to-earnings ratio (P/E) is about 18. To continue to get annualized returns of 12.5% a year from stocks, the market’s P/ E would need to rise to 25. That’s just not sus­tainable. It wasn’t sustainable back in the giddy days of 1999, and it won’t be sustainable over the next decade.

How can fund investors pre­pare for years of lower returns?

For starters, they should control what they have control over when choosing mutual fund investments - costs, ex­pense ratios and tax efficiency.

Next, consider having a large chunk of foreign equity in the portfolio. I’m well known for ignoring overseas investments - I thought they were too expensive and too full of speculative ac­counting practices. However, I’m worried about the US economy now - our excessive borrowing for costly wars, an underfinanced pension system and the dollar’s weakness. In the next few years, I’m planning to put as much as 20% of my equity holdings into foreign stocks. That includes 10% in developed coun­tries and 10% in emerging markets.

Third, don’t equate simplicity with stupidity. Warren Buffett likes to say that for investors as a whole, returns decrease as motion increases. In other words, more trades won’t necessarily boost returns. In fact, the less trading investors do, the better off they tend to be.

How do you pick investments?

I allocate my assets in such a way that I have to peek at how they are doing only once a year, and I probably won’t change that formula for the rest of my life. It provides decent returns in both good and bad market years.

My portfolio now includes 60% eq­uities and 40% bonds. In the equity portion, I have 80% in Vanguard Total Stock Market Index Fund (VTSMX) and 20% in several other Vanguard funds, including Explorer (small-cap growth stocks, VEXPX)…PRIMECAP (large­-cap blend of growth and value stocks, VPMCX)…Wellesley Income (high­-yielding stocks and bonds, VWINX)… Wellington (stocks and bonds, VWELX)…and Windsor (large-cap value stocks, VWNDX). In the bond portion, I have 50% in Vanguard Total Bond Market Index Fund (VBMFX) and 50% in Vanguard Intermediate­ Term Tax Exempt Fund (VWITX).

You favor index funds, but in­dexing peaked at about 10% of all mutual fund assets in 2000. Why hasn’t its popularity grown?

Broad stock market returns have not been great, so people are not content to just match broad indices by investing in traditional index funds. There are new index funds that give more weight to small-cap and value stocks, which have had a stellar run for the past seven years - but they don’t have enough of a track record to attract many investors.

I don’t think traditional index funds need to be fixed - they’re not broken. Not only do they work beautifully in hull markets, but they also hold up well in periods of modest returns, when investment management fees, transaction costs and taxes take a disproportionate bite out of most funds. These costs don’t take as much out of index funds, because they trade less frequently.

Even though S&P 500 index funds have returned only 8.3% per year this decade, on average, they have beaten 69% of all large-cap funds. And as foreign stocks beat domestic stocks over the past five years the Vanguard Total In­ternational Stock Index Fund (VGTSX) beat 90% of the funds in its category.

But there are still plenty of ac­tively managed funds doing much better than index funds.

Agreed, but will the managers responsible for superior returns stick around for the next 10 years? Will the funds become so popular that they get bloated and their returns revert to the mean?

I tell investors who are sick of hear­ing me tout the benefits of index funds that they must, at least, be disciplined. Keep 95% of your portfolio in index funds, and use the rest to pick stocks or actively managed funds. Choose man­agers who invest in their own funds and I follow distinctive, long-term philoso­phies without hugging benchmarks.

Here are some of my favorite mutual fund families now - Dodge & Cox (800­-621 -3979, www.dodgeandcox.com)… Oakmark (800-625-6275. www.oakmark.com)… Royce (800-221-4268, www.roycefunds.com)…Torray (800-443-3036, www.torray.com)…Tweedy, Browne (800-432-4789, www.tweedybrowne.com)… and Weitz (800-304­-9745, www.weitzfunds.com). Make a 10 year commitment and don’t hail out if your managed fund underperforms its benchmark index in any given year.

Reprinted with the permission of:

Bottom Line/(name of publication/website)

Boardroom, Inc.
281 Tresser Blvd, 8th Floor
Stamford, CT 06901
www.BottomLineSecrets.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.