The Cost of Owning a Mutual Fund

Although mutual funds can be a good way to diversify your investments across many securities, it can be an expensive way.   There can be many fees associated with owning a mutual fund, and it’s not always obvious how much you are being charged. The fund’s prospectus is the definitive source for identifying the fees. However, the prospectus can be 50 pages long and if you own 10 or more mutual funds you may not get around to determining the fees associated with each fund.

Many sellers of mutual funds tout them as “no load”. No load means that there is no sales charge paid to a broker. Investors may mistakenly believe that there won’t be any fees associated with owning the fund. But, loads are only part of the story as far as charges go. The key point to remember is that everyone wants to get paid, and your money is the source of that payment. The following fees are generally expressed as a percentage of your investment balance.  For example, if you have $10,000 invested in a mutual fund and there is a 1.5% Annual Expense fee associated with it, you’ll be charged $150 every year. $100,000 translates to $1500 in fees, etc. Here are some examples of fees charged by mutual funds that you may not be aware of.

1)      Redemption Fee – not considered a sales load even though it is deducted from redemption proceeds, just like a sales load.

2)      Exchange Fee – If you transfer from one fund to another you might be charged this fee.

3)      Account Fee – A type of maintenance fee that might be charged if your account drops below a certain dollar value.

4)      Purchase Fee - Some funds charge this fee when you buy their shares. It is not considered a load because it is paid to the fund instead of to the broker.  That’s right, they are charging you for buying their fund.

5)      Management Fee – This fee is paid to the fund’s investment advisor for managing the fund’s portfolio.

6)      Distribution (12b-1) Fees – Used to market the fund to other investors and pay brokers for selling shares of the fund.

7)      Other Expenses – If fees aren’t included in the Management Fees or Distribution Fees categories, they are included here. Examples are custodial, legal, accounting, transfer agent, and custodial expenses.

As you’ve seen, sales loads are just one of 8 potential fees associated with a mutual fund. Mutual funds are required to list these fees in the Fund Prospectus.  The Load plus the first three fees are considered Shareholder Fees and are listed under that heading in the prospectus. Fees 4 through 7 are considered Annual Operating Expenses, and appear under that heading in the prospectus. As the title suggests, they are recurring charges.

Mutual funds will list a Total Annual Operating Expenses item.  Although this helps in identifying a part of the expenses, it only includes the annual operating expenses (items 5, 6, and 7). As an alternative to digging through the fund prospectus, you might want to use the Morningstar.com website. Morningstar not only provides expense information, but rates the funds and provides historical yield information in addition to other important information.

The actual fees charges by mutual funds vary considerably.  I’ve seen the Annual Operating Expenses range from 0.01% to over 2.5%. If you think that all of the funds charging 2.5% have higher yields than all of those charging 0.01%, you’re wrong.   Generally, fees are based on how actively the fund is managed. So a fund that is doing a lot of trading will generally be more expensive to own than a fund that just tracks an index like the S&P 500. Ironically, index funds tend to outperform the more actively managed funds and are generally less expensive to own.

Brycast provides investment advice, as well as financial planning and income tax services. If you would like help setting up a new portfolio, or evaluating a current portfolio please contact us at (512) 293-4170 or via email  to norman@brycast.com.

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High Interest Rates and Low Risk Investment

You don’t normally hear about high (relatively speaking) interest rates and low risk in the same sentence. Bank and Credit Union savings accounts are currently paying from 0.01% to 1%. However, there is a place that you can invest your money that is safer than a bank and whose interest rate is higher, the US Treasury.

In November of 2011, the Bureau of Public Debt announced that the earnings rate for Series I Savings Bonds is 3.06%, and the Series EE Bond rate is 0.60%.   The rates are adjusted every April and November, so the rates are good until April 2012.

I Bond rates are the combination of a fixed rate and semiannual inflation rate. The fixed rate applies for the life of the bond, and is currently 0%. But, the inflation rate is presently set to 3.06% and will remain there until the next adjustment date, April 2012.  EE bonds issued between November 2011 and April 2012 will earn 0.60% for the life of the bond.
Here are some quick facts about I & EE Bonds purchased electronically (not paper):

• Sold at face value; you pay $50 for a $50 bond.
• Purchased in amounts of $25 or more, to the penny.
• $5,000 maximum purchase in one calendar year.
• Issued electronically to your designated account.

If you redeem I/EE Bonds within the first 5 years, you'll forfeit the 3 most recent months' interest; after 5 years, you won't be penalized.
Interest earned from bonds is subject to federal income tax, but it’s deferred until redemption, final maturity, or other taxable disposition, whichever occurs first.  However, you may be able to exclude all of the interest from your gross income if you use the bond to pay for qualified higher education expenses. You can visit the Treasury Direct website to get more information about saving bonds. 

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Income Tax Preparation in Austin Texas
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Enrolled Agent; Registered Investment Advisor

End of Year Stock Selling to Offset Capital Gains

A relatively common year-end strategy is to sell underperforming stocks at a loss in order to offset capital gains from other stock sales. Sometimes an investor does not really want to sell the underperforming stock, and quickly repurchases the same or similar stock after the sale. This can be a problem because the transaction may be considered a wash sale. In a wash sale, the loss cannot be taken. Instead the loss is added to the basis of the repurchased stock.

If you are thinking about being clever and buying the replacement stock before you sell the old stock, the IRS had already filled that hole. Here is a small portion of what the IRS has to say about wash sales.

“You cannot deduct losses from sales or trades of stock or securities in a wash sale. A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:

1.       Buy substantially identical stocks   or securities

      2.       Acquire substantially identical stocks or securities in a fully taxable trade
      3.       Acquire a contract or option to buy  substantially identical stock or securities, or
      4.      Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA”

And, if your spouse or a corporation that you control buys substantially identical stock, you have a wash sale.

If you were involved in day-trading or frequent trading, wash sales can be a real problem because you may not be able to claim a loss until you sell the repurchased stock. On one hand, most people who buy and sell stocks are considered stock investors, as opposed to stock traders. Investors must use Schedule D to report their transactions, and are subject to capital loss limitations and wash sale rules. One the other hand, stock traders report their stock transactions on Form 4797 and related expenses on Schedule C. They are not subject to wash sale rules or capital loss limitations. However, there are strict requirements and procedures that must be followed to be considered a stock trader.

So, if you are planning on taking capital losses to offset capitals gains, wait the appropriate amount of time if you are repurchasing stocks.

Brycast Financial Planning in Austin Texas --- We Can Help
Income Tax Preparation in Austin Texas
contact: service@brycast.com http://www.brycast.com/
Enrolled Agent; Investment Advisor

The Cost of a Loan Taken From Your 401(k)

Borrowing from your 401(k) can be expensive in a way that you may not have thought of.  In my June 9^th Article I wrote about some of the good and bad characteristics of 401(k) loans. However, there is a not so obvious cost in the loan that you should be aware of.

As you may know, 401(k)s are funded with pre-tax dollars. This is great because you delay paying income tax on your contributions until you start taking money out of your 401(k) account. To be clear, a loan is not a distribution. So, you do not pay income tax on a loan…sort of. Here is an example of what can happen. Let’s assume your marginal tax rate (MTR) is 25%.  

1. Over time, you’ve contributed $10,000 to your 401(k) in pretax dollars.
2. You decide to borrow $1000, maybe you want a new TV
3. There’s probably a loan origination fee, maybe $50
4. Loan interest rate may be a little high, but you’re paying it to yourself…~5%
5.  You pay back the loan over a one year term. Including interest, you’ll have to pay back $1028. Unfortunately, you do it with post-tax dollars. With an MTR of 25%, you’ll have to earn $1371 to pay back the original $1000.

In the end, that $1000 loan cost you $421 ($50 + $371). Naturally, the cost scales with your MTR, interest rate, loan term and amount borrowed. But as you can see, the repayment using after tax dollars is expensive. And here's another no so obvious cost. When you finally take distributions from your 401(k),  you'll have to pay tax on 100% of the distributions. So, before you decide to borrow money from your 401(k), carefully consider all of the costs and risks.

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Income Tax Preparation in Austin Texas

contact: service@brycast.com http://www.brycast.com/

Enrolled Agent; Investment Advisor

Restricted Stock Units (RSU) -- Potential to be Double Taxed!

If your employer grants RSUs (Restricted Stock Units) to you, count your blessings. This is a method of rewarding employees for exceptional contributions, loyalty, or just wanting to say “thanks”. However, there are some things that you should know about the way RSUs are treated from an income tax perspective so that you will not be double taxed.

First of all, RSUs are taxed as ordinary income to you, not capital gains. This sometimes confuses people because most of the time stocks and capital gains go together. When your employer grants RSUs to you, there is a restriction associated with them. Usually, the restriction is that you cannot sell the stock until a certain amount of time has passed, aka vesting period. Typically, an employee will vest in a certain percentage of the granted RSUs every year. For example, it could be that your employer granted 400 RSUs to you that proportionally vest over a 4 year period. This means that you will be vested in 100 RSUs every year for the next 4 years. Every year, once the vesting period is passed, two things happen. Your employer will add the value of the RSUs that vested to your income. And, you will be able to sell the vested RSUs.

Large employers usually relegate the RSU transactions to a broker. Your employer might initially set up the account for you, so you can see how many RSU you have, and when they will vest. Once you become vested in the RSUs, your employer will add the value of the RSUs to your income (assuming an 83(b) election was not made). He’s also obligated to withhold taxes from the distribution, usually referred to as backup withholding. If your employer uses a broker to handle the RSUs, he’ll require that just enough of the vested RSUs be sold to potentially cover all income and social security taxes resulting from the vesting. This is known as Sell to Cover. However you can select another option to sell all of the vested RSUs. This is usually referred to as a Same Day Sale. If you elect the Same Day Sale option, post-deductions proceeds are deposited into your cash brokerage account.

Here is an example of how the double taxation can occur. Let’s say your employer granted 1000 RSUs to you last year. You become vested in 250 shares this year. On the day that you become vested, the stock value is $50. Also, let’s say that you setup the Same Day Sale option in the brokerage account. On the day that you become vested, your broker will sell 250 shares of stock on your behalf. The gross amount from the sale is $12,500 (250sh * $50/sh). However, your broker will probably withhold a fee, maybe $100, for executing the transaction. And, your broker will transfer some amount to your employer to help pay the taxes due. Assume the transfer for taxes is 28% of the sale, or $3500. Whatever is left over, $8900 in this case, is deposited into your cash account at the brokerage firm.

Your end-of-year W-2 will show that you received $12,500 of additional income, and it will also show the $3500 of additional tax paid. Also, you broker is going to issue a 1099-B to you, and therein lies the problem. In this example, your broker should report net proceeds of $12,400 ($12,500 - $100 commission). You must report this 1099-B transaction on your income tax. How you handle it is very important. Your cost basis on the transaction is what the stocks sold for, $12,500. So this essentially turns out to be a short term capital loss on your Schedule D. If you fail to report it, the IRS will assume that your cost basis is zero, and will want you to pay the additional income tax, plus interest and penalties. I’ve seen some people report the transaction with zero cost basis because their employer gave them the stock! Ok, it was a gift, but the employer has already added it to your W-2 income. So, be sure and report the correct basis.

If you sell the stock as soon as you become vested, it’s known as a Same Day Sale. But, if you sell just enough shares to cover the estimated taxes due, it’s known as a Sell to Cover.  

Remember, as soon as you become vested in the RSUs, your employer adds their value to your W-2 income and tax is due. So what happens if the value of the stock that you didn’t sell drops? Well, it’s too bad. You’ve already paid taxes on the RSUs, and it doesn’t matter that their value has decreased. In fact, you can’t get any relief until you sell the stock. Then, you can enter a capital loss on your tax return. Notice I said capital loss, not ordinary loss. Although you can use capital losses to offset capital gains, you can only deduct $3000 of capital losses per year.

If the stock price increases, you are in good shape. If you wait more than a year to sell the stock, then you can report the stock sale as a long-term capital gain. Otherwise, it’s a short-term capital gain.

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Income Tax Preparation in Austin Texas
contact: service@brycast.comhttp://www.brycast.com/
Enrolled Agent; Investment Advisor

Employer Matching in Roth 401(k), Roth 403(b) and Roth 457(b) Plans

Most people understand the employer matching concept as it applies to traditional 401(k), 403(b) and 457(b) plans. In these plans, employees make pre-tax contributions and employers make pre-tax matching contributions into the employees’ accounts. Usually, there is vesting period for the employee before he gains access to the employer matching funds. However, employees are always 100% vested in their own contributions.

When it comes to Roth 401(k), Roth 403(b) and Roth 457(b) plans, the mechanics are different. The IRS states that the “Roth” prefix does not create a new plan. Instead, Roth defines the type of contribution being made to the plan. Designated Roth contributions are included in your gross income, unlike non-Roth contributions. However, your employer’s matching contribution goes into a pre-tax account, just like the non-Roth versions of the plan. Here is an example.

Let’s say you make $100,000 per year and you elect to contribute 5% of your salary to your employer provided 401(k) plan. And, your employer matches 100% of your contribution to the plan. So, you contribute $5000 to your account, and your employer matches your contribution, contributing $5000. The total deposit into your account is $10,000. Your employer will report that your salary is $95,000 for the year (W-2 Box 1). When you withdraw the money from your 401(k), you’ll have to pay tax on the entire withdrawal. If that $10,000 grew to $12,000, you would have to pay tax on $12,000.

Using the same facts as before, but you now contribute to a Roth 401(k). Your $5000 contribution goes into your post-tax account, but your employer’s matching contribution goes into a pre-tax account. The total deposit into your account is still $10,000. However, your employer will report that you made $100,000 (W-2 Box 1), instead of $95,000. Also, let’s assume that the $10,000 contribution also grows to $12,000. When you withdraw the $12,000, you will only need to pay tax on $6000, instead of $12,000.

In summary, even though you contribute to a Roth plan, the employer matching contributions are treated as if the plan is non-Roth.

For more information, read the IRS FAQ.

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Income Tax Preparation in Austin Texas
contact: service@brycast.comhttp://www.brycast.com/
Enrolled Agent; Investment Advisor

Small Business Introduction (3) – The General Partnership

Previously, I discussed the Sole Proprietorship and the Single Member LLC. Although it might seem natural to discuss the Multimember LLC next, I’m going to talk about the General Partnership instead. The reason is that if I were to discuss the MM-LLC, I would have to mention partnerships.

General Partnership

A General Partnership (GP) is a joint business venture between two or more persons or entities.  Normally, a GP does not have to be registered with the state; it is automatically formed when two or more persons conduct a for profit business together.  Ownership and control of a GP is generally determined by how much capital is contributed. If there are 4 partners in a GP, and each one contributed equally to its formation, everyone would be a 25% owner. Partners share in the profits and losses of the GP according to their ownership interest. Although not required, there should be a written partnership agreement. The agreement should spell out the rights and responsibilities of the partners.  A lawyer may be required to draft thorough partnership agreement, but there are templates available that may serve your purpose.

Sometimes friends or relatives engage in an informal partnership where they might buy a duplex or co-own some other property together.  This is generally referred to as a co-ownership.  Although there are obvious advantages to sharing upfront expenses, this type of relationship can have many, sometimes disastrous, consequences.  Co-owner disputes can erupt early, or down the road as personal situations change. You should strongly consider engaging an attorney produce a co-owners agreement for you at the start of your relationship.

 

Liability

Each partner is jointly and severally liable for the partnership’s obligations. Each partner’s personal assets are at risk and can be seized in order to satisfy the partnership’s obligations. In a way, this is similar to the liability of a Sole Proprietorship, except a partner has potentially more exposure to risk. 

Income Tax Reporting

Partnerships must file IRS Form 1065, Return of Partnership Income. The partnership itself should have an accountant to keep track of partnership income and expenses, as well as the partner’s basis. Preparing Form 1065 is a task that should be left to a tax pro. The partnership then issues a Schedule K-1 (Form 1065) to each partner.  Anyone receiving a K-1 must report the K-1 items on their individual tax return.   Unfortunately, this may require tax preparation knowledge beyond the expertise of most individuals. K-1 entries can flow into many unfamiliar tax forms, so use a tax professional like an Enrolled Agent to prepare your tax return.

Additional Taxes

There are no taxes unique to a GP, but depending on the partnership’s activities, partners may have to report income from rentals, royalties, capital gains, ordinary, interest, etc.

Brycast Financial Planning in Austin Texas --- We Can Help
Income Tax Preparation in Austin Texas
contact: service@brycast.com http://www.brycast.com/
Enrolled Agent; Investment Advisor