Volume XXXVIII: Frank Armstrong, author of Investment Strategies For The 21st Century, answers questions from members of the MFI community. To submit a question to Frank, please write to us.

Questions and Responses

Must I take my annual distribution from my IRA before converting to a Roth IRA?

How can I spread out the tax burden on my mutual funds' capital gains?

How should we invest money we might need for expenses?

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Must I take my annual distribution from my IRA before converting to a Roth IRA?

from Arthur

Q: I take minimum yearly distribution from my IRA account. I now want to convert this account to a Roth IRA to do this the bank where I have my IRA account said I must take my yearly distribution for the year 98. I would like to convert my total balance at this time to a Roth Ira. My question is whether this is mandatory by IRS.

A: As I understand it, you must take your minimum required distribution this year, and then you are free to convert the balance.

The technical corrections act is supposed to settle the issue of whether the distribution will count against the $100,000 maximum income limit for conversion. Right now it appears that it does count against the limit, which prevents some taxpayers from being able to convert.

For the latest information on the Roth IRA, check out www.rothira.com.

However, if the amount involved is more than a nice dinner would cost you, I would strongly urge you to consult with a real tax professional, a CPA, or tax attorney. I am neither, and columns like this are for general information only.

How can I spread out the tax burden for my mutual funds' capital gains?

from Marc

Q: I currently own Janus Fund and Janus Twenty mutual funds. At the end of year when taxes are due I am hit with a huge tax bill due to the increased gains from my two mutual funds. What is the best way to spread this tax burden over the year so I am not hit with paying the additional tax all at once at the end of the year.

My neighbor owns some mutual funds whose management will deduct the tax throughout the year. He had to request this special service as he told me it is not advertised. Janus states they don't offer this service even if requested. Maybe I should increase my dependents withholding on my W-4 form and claim one or two less dependents so my employer (U.S. Army) holds more taxes out of my pay. What is your recommendation?

A: First, thanks for serving in the US Army. All of us owe you.

You could ask the Army to increase your withholding, or you make quarterly estimated tax payments. On the other hand, why put up with all that extra tax exposure? It's hard to imagine that on an after tax basis, any managed fund can generate enough "alpha" to be worth the extra "management" risk. Funds with high turnover take what should be a long term deferred gain and turn it into ordinary taxable income. This is the source of your tax pain.

As any investor should be aware, there are now at least four tax categories.

Deferred gains are not taxed until sold. Zero tax bracket.

Gains on assets held over 18 months are a maximum of 20%.

Gains on assets held between 12 and 18 months are taxed at a maximum of 28%.

Ordinary income or gains on assets held less than 12 months are taxed at a maximum of 39.6%.

State income taxes are extra!

If a fund generates taxable events, those taxes get passed on to the shareholders. This reduces the nominal gains by the amount of the tax.

Index funds have negligible turnover, so shareholders get to keep the vast majority of their gains, and they get to pick the day that they realize those gains. Since most managed funds can't beat the appropriate index anyway, even on a before tax basis, it makes sense to use index funds. The probability is high that you will make larger gains, and keep more of them.

So, I would have to take a hard look at dumping your funds and buying some of the Vanguard or Schwab Index Funds.

How should we invest money we might need for expenses?

from Debbie

Q: My husband and I both work to make ends meet. we recently inherited $50,000. At some time we my need the money for expenses. What do you suggest for an investment vehicle?

A: If you need the money for expenses in the next five years, don't even think about the stock market. There is a fair chance that you might lose part of your nest egg.

Put the funds in a CD, Treasury Bill, Money Market Account, or very short term bond fund.

Copyright (c) 1998 Frank Armstrong.

Frank Armstrong is author of Investment Strategies for the 21st Century, published here, and president of Managed Account Services, Inc., a fee-only advisor specializing in global asset allocation strategies utilizing no-load mutual funds. Frank is a Certified Financial Planner (CFP) with 24 years' experience helping investors build wealth. The firm, an SEC Registered Investment Advisor currently manages in excess of $60 million for over 140 clients worldwide. Visit Frank's Managed Account Services, Inc. or call 1-800-508-8500 for more information about the Alternative to Business as Usual on Wall Street.

Copyright © 1998, Frank Armstrong.

Frank Armstrong is author of Investment Strategies for the 21st Century, published here, and president of Managed Account Services, Inc., a fee-only advisor specializing in global asset allocation strategies utilizing no-load mutual funds. Frank is a Certified Financial Planner (CFP) with 24 years' experience helping investors build wealth. The firm, an SEC Registered Investment Advisor currently manages in excess of $60 million for over 140 clients worldwide. Visit Frank's Managed Account Services, Inc. for more information about the Alternative to Business as Usual on Wall Street or call 1-800-508-8500.

Disclaimer

Investing in equities involves a serious principal risk, and no assurance can be given that the techniques described here will be successful. Returns vary and you may have a gain or loss when you sell your shares. Past performance is no guarantee of future results. Index returns shown are historical and include the change in share price, reinvestment of dividends, and capital gains. Indexes are unmanaged and do not reflect the impact of transaction costs. Transaction costs would have reduced the total returns.

International investments, especially those in emerging markets, entail greater risks (as well as greater potential rewards) than U.S. investing. These risks include political and economic uncertainties of foreign countries, as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less-established markets and economies.

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