Author: Jesse Mackey

This article represents part 2 of 3 in this series. Please see yesterday’s post as well as tomorrow’s for the full article.

In the event that assets cannot be invested in an account/plan that allows for tax deductions, tax deferral, or tax elimination, the following seven techniques are excellent ways to reduce the tax burdens associated with investing in currently taxable accounts, such as jointly titled, trust-owned or individual accounts, which may come in the form of brokerage accounts, fee-based managed advisory accounts, or direct subscription investment vehicles.

Municipal Fixed Income – Possibly the most traditional method of tax minimization for high income tax bracket investors is the use of bonds issued by government municipalities, which are typically free of income taxation if purchased by an investor that resides in the state in which the security is issued, even if purchased within a currently taxable account. Muni’s are useful both for tax minimization purposes and for portfolio diversification purposes, but may not be beneficial in large quantities for all investors.

Low Turnover Managers – When purchasing mutual funds or hiring individual security Separately Managed Account (SMA) managers, it is useful to consider the amount of active trading that will occur in the fund/account during the course of the year, as this will often be indicative of the amount of capital gains taxes (short term and long term) that will be realized in an up-market scenario. Lower portfolio turnover often indicates lower realized (as opposed to unrealized) capital gains, whereas higher turnover managers may indicate a higher propensity to generate tax liabilities for the investor.

Separately Managed Accounts (SMA) and Individual Stocks – It is often cited that the use of individual securities (stocks and bonds) in a brokerage account or SMA will, all things being equal, generate lower current tax liabilities for investors than the use of mutual funds. This is because mutual funds, as pooled investment company vehicles, may distribute capital gains and dividends to all investors regardless of whether the individual investor was able to participate in the full benefit of the appreciation in value of the underlying holdings of the portfolio (because the fund may have been purchased after the majority of the price appreciation, but before distribution of the full capital gain liability by the fund). SMAs are not pooled investment vehicles, and therefore holdings purchases/sales are specific to the individual investor, allowing managers to actively customize the transactions in the portfolio to the tax situation of the individual, thus reducing unwarranted tax liabilities.

Fund Dividend and Capital Gains Distribution Awareness- The flipside of the above argument regarding the tax-efficiency of individual securities is that a portfolio composed of mutual funds, if managed properly, may be just as tax efficient as an individual-securities-only portfolio while also providing the investor with the full investment diversification necessary to reduce long term portfolio volatility. If this is to be accomplished, the mutual fund portfolio manager must make purchases and sales of the component mutual funds with an awareness of any upcoming fund dividend or capital gains distributions in order to avoid these if unwarranted for the investor, and to avoid “selling dividends” which is a prohibited practice. The mutual funds may also be selected based on the manager’s professed tax-efficient style of investment, or based on a history of asset type tax efficiency.

The series concludes tomorrow…to be continued…

Jesse Mackey is a partner and Investment Officer of 4Thought Financial Group Inc. 4Thought was created with the base vision of advancing individual freedoms and the human quality of life through economic means. This vision is pursued by applying the firm’s four specialties – Economic Theory and Research; Multi-Contingency Investment Management; Financial Planning for Business Owners and Individuals; and Support for Partner Firms and Advisors.

Contact:

Jesse Mackey

4Thought Financial Group Inc.

www.4TFG.com

jmackey@4TFG.com

Why is This Topic Important to Wealth Managers? This blogticle is part of our Casual Friday series. Here we discuss recent enforcement actions brought by the SEC with regards to the financial crisis. Chances are clients, you or someone you know is currently involved in, or has been involved with one of the entities discussed below.

Goldman Sachs – The SEC charged the firm with defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter.  The firm agreed to pay record penalty in $550 million settlement and reform its business practices.

J.P. Morgan Securities – The SEC charged the firm with misleading investors in a complex mortgage securities transaction just as the housing market was starting to plummet. J.P. Morgan agreed to pay $153.6 million in a settlement that enables harmed investors to receive all of their money back.

Wachovia Capital Markets – The SEC charged the firm with misconduct in the sale of two CDOs tied to the performance of residential mortgage-backed securities as the housing market was beginning to show signs of distress. The firm settled charges by paying more than $11 million, much of which will be returned to harmed investors.

Citigroup – The SEC charged the company and two executives with misleading investors about exposure to subprime mortgage assets. Citibank paid $75 million penalty to settle charges, and the executives also paid penalties.

Countrywide – SEC charged CEO Angelo Mozilo and two other executives with deliberately misleading investors about significant credit risks taken in efforts to build and maintain the company’s market share. Mozilo also charged with insider trading.

Charles Schwab - SEC charged entities and executives with making misleading statements to investors in marketing a mutual fund heavily invested in mortgage-backed and other risky securities. Schwab entities paid more than $118 million to settle charges.

State Street – The SEC charged the firm with misleading investors about exposure to subprime investments while selectively disclosing more complete information to specific investors. State Street agreed to repay investors more than $300 million to settle the charges.

TD Ameritrade – The SEC charged the firm with failing to supervise representatives who mischaracterized the Reserve Fund as safe as cash and failed to disclose risks when offering the investment to customers. The firm settled charges by agreeing to repay $10 million to certain fund investors.

Bank of America – The SEC charged the company with misleading investors about billions of dollars in bonuses being paid to Merrill Lynch executives at the time of its acquisition of the firm, and failing to disclose extraordinary losses that Merrill sustained. Bank of America paid $150 million to settle charges.

To date the SEC has charged approximately 70 entities and individuals. The SEC has imposed total penalties, disgorgement, and other monetary relief of approximately $1.65 billion.

Next week’s blogticles will discuss issues surrounding wealth management planning for the fall of 2011.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

Why is This Topic Important to Wealth Managers? Our discussion today is focused on Annuities. There has been a lot of talk recently in the major media about the use of Annuities to meet certain financial planning objectives. We thus continue this discussion which focuses on how wealth managers can take advantage of the situation.

Earlier this week, Advisor’s Journal presented an article discussing a recent Securities Litigation & Consulting Group white paper which captures the sentiments of the anti-annuity press, commenting that, “[a]nnuities stand out as the investment most likely to be unsuitable since in virtually every instance, the investor would have been better served by mutual fund or a portfolio of individual stocks.” See AMAFX: Annuities: They Get No Respect. [1] But the bad press may be unwarranted.

National Underwriter reports variable annuities in 2010 were bullish by virtually all measures. 2010 new sales totaled $136.6 billion, an increase of 10.3% over 2009 sales of $123.9 billion. [2]

New sales surged in the 4th quarter of 2010, reaching $37.1 billion which represents a two-year quarterly high and posting a 17.4% increase over 4th quarter 2009 new sales of $31.6 billion.

Furthermore, year-end assets under management reached a milestone of just over $1.50 trillion, an 11.2% increase over year-end 2009 assets of $1.35 trillion and the highest recorded in almost 20 years of variable annuity asset tracking. This also represents a return to pre-financial crisis asset levels as the previous high water mark of $1.49 trillion was reached in the third quarter of 2007.

Not since 2006 has the change in year-over-year net flow been more positive than the change in sales, and at 15.7% the ratio of net flow to new sales was the highest since 2007; both measures point to improvement in terms of new money vs. exchange fueled sales.

Advisor’s Journal also reported earlier this year that sales of variable annuities (VA) with guaranteed living benefit (GLB) riders continue to grow exponentially, according to LIMRA’s Variable Annuity Guaranteed Living Benefit Election Tracking Survey. The Survey showed a 78 percent increase in assets of VAs with GLB riders, from $292 billion in the fourth quarter of 2008 to $521 billion in the fourth quarter of 2010. See Advanced Markets Advisor FX: Guaranteed Living Benefit Riders Breathe Life into Variable Annuity Sales [3]

As Sterling noted earlier this week, the case studies too represent a positive outlook. He cites to an article by Professor Richard H. Thaler, a University of Chicago professor, which explores one example showing the value through stability and security to the average individual planning for retirement. [4]

The Professor asks readers to assess the financial challenges of identical twins approaching retirement. One twin has a pension that will pay him $4,000 a month for the rest of his life. In contrast, his brother will sustain his retirement income by withdrawals from self-directed accounts. Financial projections confirm this brother has enough assets to fund his retirement through age eighty-five—an age he has a 30 percent chance of reaching. This assumes financial conditions based on historical averages; hardly a fair representation of events during the past decade.

Professor Thaler surmises that, when given the choice between the two retirement options, “nearly everyone” would prefer the guaranteed pension to the uncertainty of self-managed investments.  In sum, according to the Professor, annuities purchasers generally end up with more post-retirement income than their peers.

Tomorrow’s blogticle will present discussion on issues surrounding the wealth management practice.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

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[1] Citing Craig McCann  & Kaye Thomas. Securities Litigation and Consulting Group. Annuities. http://www.slcg.com/pdf/workingpapers/Annuities.pdf. Last Accessed 6/20/2011.

[2] Frank O’Connor A Year to Remember. National Underwriter Life & Health. April 4, 2011. http://www.lifeandhealthinsurancenews.com/Issues/2011/April-4th-2011/Pages/A-Year-to-Remember.aspx?page=2. Last Accessed 6/20/2011.

[3] Citing LIMRA. Assets of Variable Annuity with Guaranteed Living Benefit Riders Improve By Almost 80 Percent in Two Years, LIMRA Reports. March 8, 2011. http://www.limra.com/newscenter/NewsArchive/ArchiveDetails.aspx?prid=170. Last Accessed 6/20/2011.

[4] Citing Richard H. Thaler. The Annuity Puzzle. New York Times. June 4, 2011. http://www.nytimes.com/2011/06/05/business/economy/05view.html?_r=2&adxnnl=1&emc=eta1&adxnnlx=1307963257-8N4qBWZGH3BH8+ydWXq9TQ. Last Accessed 6/20/2011.

We’re all aware that annuities get a bad rap in the media: High fees, high-pressure sales, and unsuitability are the predominating themes.

A recent Securities Litigation & Consulting Group white paper captures the sentiments of the anti-annuity press, commenting that, “[a]nnuities stand out as the investment most likely to be unsuitable since in virtually every instance, the investor would have been better served by mutual fund or a portfolio of individual stocks.”

Annuities are neither inherently “good” nor “bad.” It follows that rational evaluation of annuities can’t be conducted in a bubble—it must focus on their application.  Herein lays their value and the coup de grâce the industry and individual producers have been awaiting.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of annuities in Advisor’s Journal, see How Much to Allocate to Annuities: A Critical Analysis (CC 11-109).

For in-depth analysis of the income taxation of annuities, see Advisor’s Main Library: Section 19.2 Income Taxation of Annuities.

Author: Jesse Mackey [1]

Why is this Topic Important to Wealth Managers? This blogticle represents a special series regarding advanced investing with ETFs. Recently there has been much discussion in the marketplace on the use of these tools and thus we present this topic for wealth managers who may consider these investment vehicles for their clients.

Since the advent of ETFs (Exchange Traded Funds), these investment vehicles have rapidly grown to account for a significant portion of the daily trading volume on the world’s major exchanges, and by some estimates will account for the majority of trading volume during the next decade. But despite the widespread use of ETFs in the institutional investment world, few individual investors or their wealth managers really have a firm grip on the uses or purposes of these instruments. Although there are many different flavors of ETF, generally speaking ETFs can be described as a mutual fund designed to passively track a specific securities index that can be traded like a stock on an exchange. This leads us to identify several attractive characteristics of ETFs for your clients:

Transparency of Indexes – Most ETFs (though not all) are designed to replicate the performance of a specific index, which is in turn designed to mimic the performance of a specific financial market (i.e., large cap stocks, short term corporate bonds, etc.). As a result, the client is able to achieve direct exposure to the specific area of the financial markets that is being targeted, without much question as to the “style drift” or the management methodology of the underlying portfolio. There is a great deal of transparency and clarity for the investor as to the reason and timing for transactions placed within their ETF holdings.

Lower Manager-Specific Risks- In index-tracking ETFs there is a lower degree of exposure to active manager-specific risks for the investor. Since the ETF is designed to passively follow an index regardless of the positive or negative performance of the underlying securities, there is very little exposure to the risks associated with the potential underperformance of any one active manager, which would otherwise be present with a traditional actively managed mutual fund. The average active manager has a tendency to over-perform the index in some years and under-perform the index in others, whereas the passively managed ETF is intended to do exactly what the index does, and so will not dramatically over or under-perform, by design. However, ETFs do have a form of risk known as tracking error, in which the ETF itself may not exactly replicate the benchmark index, due to a multitude of factors.

Intraday Tradability – ETFs are traded in real time on an intraday basis on an exchange, as opposed to being redeemed daily by the mutual fund company (like a traditional open-end mutual fund). As a result, investors are able to buy or sell the security with greater control over the timing and price. As with shares of stock, investors can place market orders, limit orders, stop orders, etc. This creates opportunities for active management that would not otherwise be available with a traditional mutual fund.

Targeted Exposures – ETFs allow your client to gain targeted exposures to very specific sectors or areas of the financial markets, while still maximizing numerical security diversification to the extent possible within the selected market, and without having to select individual securities (stocks, bonds, etc.). For example, a client could select an ETF that provides exposure to US Consumer Staples stocks, which might have an underlying portfolio of 40-100 stocks that provide access to an entire sector of the economy. This has implications for portfolio management both from the strategic asset allocation perspective, and for tactical asset allocation methodologies.

Low Turnover and Tax Efficiency- One commonly cited reason to consider using ETFs is for the purposes of tax efficiency relative to traditional mutual funds. Traditional actively managed mutual funds may have a high degree of underlying portfolio turnover as a result of the rapid buying and selling of securities. High volume/frequency transactions can produce tax liabilities whether the purchase/sale was ultimately beneficial for the overall portfolio or not. Because ETFs usually track an index, which often will not experience a large degree of change in the components over short periods, ETF turnover ratios are usually very low. In addition, as a result of the “Creation Unit” structure under which ETFs are issued, the holder’s exposure to taxation due to fund redemptions is reduced or eliminated. All things being equal, these features may result in less tax liability for the investor when it’s time to file the return.

Tomorrow’s blogticle will continue our special series on ETFs.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] Jesse Mackey is the Chief Investment Officer of 4Thought Financial Group Inc. 4Thought is a boutique think tank created with the base vision of advancing individual freedoms and the human quality of life through economic means. This vision is pursued by applying the firm’s four specialties – Economic Theory and Research; Multi-Contingency Investment Management; Financial Planning for Business Owners and Individuals; and Support for Partner Firms and Advisors. You may contact Mr. Mackey at jmackey@4TFG.com or visit www.4TFG.com.

Why is this Topic Important to Wealth Managers? This topic discusses a relatively new form of retirement investment offered by companies to their employees. The topic presents information about target date funds, what they are, who may use them and how they work. The defined contribution retirement market is a prime location for wealth managers to earn fees and commissions. Thus, staying informed about new market updates is provided to give managers an edge when exploring retirement benefits. 

The Government Accountability Office recently published a report stating that financial security of millions of Americans in their retirement years will substantially depend on their savings in 401(k) and other defined contribution (DC) plans. [1] The GAO notes, to help ensure adequate financial resources for retirement, participants in DC plans should make adequate contributions during their working years and invest contributions in a way that will facilitate adequate investment returns over time.

To that end, the Pension Protection Act of 2006 (PPA) included various provisions designed to encourage greater retirement savings among workers eligible to participate in 401(k) plans, such as provisions that facilitate plan sponsors’ adoption of automatic enrollment policies. [2]

Under such policies, eligible workers are automatically enrolled unless they explicitly decide to opt out of participation. Because an automatic enrollment program must also include a default investment—a vehicle in which contributions will be invested absent a specific choice by the plan participant—the act also directed the Department of Labor to assist employers in selecting default investments that best serve the retirement needs of workers who do not direct their own investments. Since that time, target date funds (TDF)—that is, investment funds that invest in a mix of assets, and shift from higher-risk to lower-risk investments as a participant approaches their “target” retirement date—have emerged as by far the most popular default investment.

TDFs are designed to provide an age appropriate asset allocation for plan participants over time.    However, target date funds vary considerably in asset structures and in other ways, largely as a result of the different objectives and investment philosophies of fund managers. In the years approaching the retirement date, for example, some TDFs have a relatively low equity allocation—35 percent or less—so that plan participants will be insulated from excessive losses near retirement. Other TDFs have an equity allocation of 60 percent or more in the belief that relatively high equity returns will help ensure that retirees do not deplete savings in old age. 

TDFs also vary considerably in other respects, such as in the use of alternative assets and complex investment techniques. In addition, allocations are based in part on assumptions about plan participant actions—such as contribution rates and how plan participants will manage 401(k) assets upon retirement—which may differ from the actions of many participants. These investment differences and differences between assumed and actual participant behavior may have significant implications for the retirement security of plan participants invested in TDFs.   

Moreover, recent TDF performance has varied considerably, and while studies show that many investors will obtain significantly positive returns over the long term, a small percentage of investors may have poor or negative returns. [3]  Between 2005 and 2009 annualized TDF returns for the largest funds with 5 years of returns ranged from +28 percent to -31 percent. Although TDFs do not have a long history, studies modeling the potential long-term performance of TDFs show that TDFs investment returns may vary greatly.  For example, while one study found that the mean rate of return for all individual participants was +4.3 percent, some participant groups could experience significantly lower returns. These studies also found that different ratios of investments affect the range of TDF investment returns and offer various trade-offs.

TDFs offer investors a number of potential advantages. First, they relieve DC plan participants of the burden of deciding how to allocate their retirement savings among equities, fixed income, and other investments. Thus, TDFs offer participants a professionally developed asset allocation based on their planned retirement date. TDFs thereby can help plan participants and other investors avoid common investment mistakes, such as a lack of diversification and a failure to periodically rebalance their assets.

Second, TDFs are designed to strike a balance between an age-appropriate level of risk and potential investment return. In general, a TDF provider will include a series of funds designed for participants expecting to retire in different years, such as 2010, 2015, 2020, 2025, and so on. A plan participant who is 30 years old in 2011, for example, might be defaulted into a 2045 TDF, while a 55-year-old participant would likely be defaulted into a 2020 TDF. Typically, a TDF will shift from primarily equities to fixed income investments as a participant approaches his or her retirement date, in the belief that fixed income investments generally pose lower risk. This shift can be represented graphically as a line commonly referred to as the glide path.

TDFs are often established as mutual funds in a fund-of-funds structure. That is, the TDF is a composite of multiple underlying mutual funds in different asset classes. Generally, TDFs consist of an equity component and a fixed income component.

The major asset classes, in turn, may be composed of funds representing different sectors of the major asset classes. For example, the equity component may consist of some funds focused on equities of large U.S. corporations, international equities, or equities of smaller companies. Similarly, the fixed income component may consist of various bond funds, such as funds consisting of government and corporate bonds.

Tomorrow’s blogticle will continue to discuss new and exciting planning aspects of 2011. 

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

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[1] Government Accountability Office.  “Defined Contribution Plans–Key Information on Target Date Funds as Default Investments Should Be Provided to Plan Sponsors and Participants”. January 2011. GAO-11-118.  http://www.gao.gov/new.items/d11118.pdf.  Last Accessed 2/28/2011. 

[2] Pub. L. No. 109-280 (2006) Section 902 of PPA added Internal Revenue Code sections 401(k)(13), 401(m)(12) and 414(w); Automatic Contribution Arrangements, 74 Fed. Reg. 8,200 (February 24, 2009) (to be codified at 26 C.F.R. pts. 1 and 54). 

[3] See GAO-11-118 at 121 “GAO representation of Morningstar data”.

Why is this Topic Important to Wealth Managers? Discusses opportunity presented by the looming muni bond market.  Offers an alternative investment to muni bonds that contains similar tax benefits.

The Wall Street Journal has recently noted that significant withdrawal of funds from municipal bonds throughout the country totaled over $4 billion in a one week period. [1] According to some estimates, the withdrawal accounts for only one tenth of one percent of the overall muni bond market.  [2] Yet, the numbers are record breaking.  The withdrawal is the largest from the muni bond market since last November, reports the Wall Street Journal.

However, the trouble seems to have started well before Meredith Whitney appeared on “60 Minutes”  in late December of last year when she call for the future “collapse” of the muni bond market.  In her opinion, the state and local governments will be forced to default on obligations made to bond holders because the governmental entities are quickly running out of liquidity.  Nevertheless, the muni bond numbers reflect the ”10th straight week of outflows, which total roughly $20.6 billion.” [3]

Whitney though may have created in the muni bond market what is now known as Gladwell’s “Tipping Point”.  It reasonably appears that she has influenced an overall decline in the faith and credibility of the muni bond market.  “The four-week moving average, a more meaningful number because of the longer time span it measures, was an outflow of $2.2 billion versus an outflow of $1.9 billion in the previous four-week period.” [4]

Many individuals are aware of the bad financial positions of more than a few states.  In California alone, the budget deficit is over $25 billion.  Some are even speculating about another “bail-out” for state and local governments who can’t meet their obligations.

How does all this affect wealth managers?

What exactly will happen is yet to be decided.  However, what is currently known is many individual investors recently liquidated tax favored investments.  Furthermore, it has created a perfect opportunity to promote other tax favorable investments such as life insurance and annuity products.  Because many investors in the muni bond market are accustomed to tax free interest on their investment, and further since life insurance and annuity products offer similar tax treatment, the switch is an appealing conversion.

In fact, lately some insurance companies have repositioned their annuity products to be presented in a light that provides a safe guaranteed source of income.  Many investors who were seeking the “safety” offered by instruments backed by state and local governments are likely to be more amenable now to funding investments offered by private institutions.  Annuities specifically fit the bill, and since most companies offer a line of annuity products from fixed rate to variable and indexed, there is certainly a product out there to fit most investor’s needs.

Next week’s blogs will be discussing more market opportunities for wealth managers.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] Kelly Nolan.  Wall Street Journal. “UPDATE:Muni Mutual Funds See $4B Outflow In Latest Week—Lipper”. http://online.wsj.com/article/BT-CO-20110120-717343.html.  January 20,1011.  Last Accessed January 20, 2011.

[2] .  Nicole Bullock.  Financial Times. “Record amounts withdrawn from US muni funds.” http://www.ft.com/cms/s/0/0aae4f6a-24ff-11e0-895d-00144feab49a.html#axzz1BdnfaiYw. January 21, 2011.  Last Accessed January 20, 2010 (PST).

[3] Kelly Nolan.  Wall Street Journal “UPDATE:Muni Mutual Funds See $4B Outflow In Latest Week—Lipper”.

[4] Id.

Cost competitiveness of life insurance policies is an obvious determinant of suitability.  Keeping costs low is critical because every dollar spent on expenses is one less dollar available to purchase more death benefit.  In fact, a recent study by Morningstar revealed that “Low fees are likely to be the best predictor of a mutual fund’s future success,” and the same certainly holds true for life insurance products. 

While different insurers refer to different policy expenses in different ways, all policy expenses in all life insurance policies fall into the following four categories: 1) cost of insurance charges (COIs), 2) fixed administration expenses (FAEs), 3) cash-value-based “wrap fees” (e.g., M&Es), and 4) premium loads.   Each type of policy expense and its role and relevance in pricing and suitability is discussed in the complete analysis at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of life insurance product suitability in Advisor’s Journal, see Life Insurance Product Suitability (CC 10-90) and Financial Strength and Claims-Paying Ability (CC 10-115).

We invite your questions and comments by posting them or by calling the Panel of Experts.

Although overshadowed by the fight over the Obama tax agreement, mutual fund legislation passed the House on December 15.  The Registered investment Company Modernization Act of 2010 (RICM Act), H.R. 4337, was originally passed by the House on September 28, but the Senate amended the bill, forcing a second vote in the House.

Tax Code provisions governing mutual funds have not had a substantial update since 1986, with some components of the Code relating to mutual funds sitting untouched for sixty or more years. The tax and regulatory landscape has changed significantly in the intervening years, which has left the tax rules for mutual funds sorely in need of updating.

The RICM Act brings the Tax Code’s treatment of mutual funds and other registered investment companies (RICs) up to date by introducing the following provisions to the Tax Code, among others: Read this complete article at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of mutual fund investment in Adviso’rs Journal, see Can Term Life Coupled with a Mutual Fund Investment Replace a Variable Universal Life Policy? (CC 10-77).

We invite your questions and comments by posting them in our blog or by calling the Panel of Experts.

Author: William H. Byrnes & Benjamin S. Terner

Why is this Topic Important to Wealth Managers? Provides wealth managers with information relating to client transactions and reporting to the Internal Revenue Service beginning next year.

The Energy Improvement and Extension Act of 2008 created new laws requiring most regulated securities transactions occurring after December 31, 2010 to be subject to cost basis reporting by securities brokers to the IRS. [1] Currently, brokers are required to report the gross proceeds from the sale of a security on Form 1099. [2] The new law will add reporting of client’s adjusted basis of the security, and whether the gain is a short or long-term.  [3] Mutual fund cost basis reporting is to start a year after regulated securities reporting, and options and debt contracts are to follow a year after mutual funds.  The reports are to be filed on a Form 1099-B, Proceeds from Broker and Barter Exchange. [4]

Why is it important to know that the IRS will be receiving information about the values of securities of clients?

Generally, gain determination for the sale or exchange of a capital asset is the sales price minus what the asset was acquired for, or the cost basis. [5]

Until now, gain determination, which directly effects tax liability, has largely been a task for accountants.  The new law fundamentally changes how gains will be calculated by the Treasury;  going forward, it will have all the information it needs to calculate tax liabilities for taxpayers from transactions occurring on capital markets. [6]

Now, under Form 1099 reporting by brokers—“basis, sales price, and type of gain, the IRS can track” what was paid for the stock, what the stock was sold for, and whether the gain is short term or long term. [7] There is now little room for error for individuals purchasing securities to correctly report gains from transactions on stocks.  If the IRS receives information from the broker that does not match information on the client’s tax return, “the mismatch should trigger an IRS inquiry.” [8]

The effort is part of the Federal initiative of finding “innovative ways to reduce the tax gap and improve compliance.” [9] Internal Revenue Service Commissioner Shulman states the new law “will go a long way to reducing [miscalculated gains] and making things easier for investors.” [10]

Also, the requirements for reporting continue—a broker who transfers custody of a security to another broker must include an accompanying written statement with information to determine basis. [11] Moreover, once an issuer of stock takes an organizational action such as a stock split, merger, or acquisition that affects basis, an issuer must report to the Service and to each stockholder or nominee a description of any such action and the quantitative effect of that action on basis. [12]

The Commissioner relates to the issue personally, “I don’t know about you, but I have spent far too much time digging through old records, trying to find the basis for securities I sold.  I think investors…and I count myself one …will welcome getting this new, easy-to-understand information from their brokers.” [13] Others may disagree with the Commissioner but, time should tell.

Our Blogticles will continue Friday.  From the staff and experts at National Underwriters – we wish you a Happy Thanksgiving!

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] Section 403 of the Energy Improvement and Extension Act of 2008, Div. B of

Pub. L. No. 110-343, 122 Stat. 3765, enacted on October 3, 2008, added sections

6045(g), 6045A, and 6045B to the Code. Section 6045(g) 6045(a); Notice 2010-67.  http://www.irs.gov/pub/irs-drop/n-10-67.pdf.  Last Accessed 11/7/2010.

[2] 26 U.S.C. § 6045.

[3] Id.

[4] See  26 U.S.C. § 6045; 26 CFR § 1.6045-1.

[5] See generally, 26 U.S.C. §§ 1001, 1011, 1012.

[6] Arden Dale.  The Wall Street Journal.

Cost Basis to Come on 1099B’s.  http://online.wsj.com/article/SB10001424052748704763904575550461405074090.html.  October 14, 2010.  Last Accessed 11/22/2010.

[7] Robert W. Wood.  “Forms 1099 For Cost Basis: What, Me Worry?”.  Forbes-The Tax Lawyer.  Oct. 20 2010.  http://blogs.forbes.com/robertwood/2010/10/20/forms-1099-for-cost-basis-what-me-worry/.  Last Accessed 11/22/2010.

[8] Robert W. Wood. Forbes-The Tax Lawyer.

[9] Internal Revenue Service Commissioner Douglas Shulman.   Prepared Address to The American Payroll Association’s and American Accounts Payable Association’s 28th Annual Congress. IR-2010-68.  May 27, 2010, Washington, D.C.

[10] Douglas Shulman.  IR-2010-68.

[11] 26 U.S.C. § 6045(g).

[12] 26 U.S.C. §  6045B.

[13] Douglas Shulman.  IR-2010-68.