Plus bond diversification, annuities, and IRA deductibility.
By Sue Stevens, CFA, CFP, CPA | 09-30-04 | 06:00 AM | Email Article

Dear Sue,

My wife’s grandmother died in February, leaving a quaint and beautiful beachfront home for her two daughters. The rest of the estate is very simple: some stocks and mutual funds. The daughters would like to keep the property as a family retreat, using the residue from the estate to fund the expenses of the property for as long as they last.

Sue Stevens, CPA, CFP, MBA, and CFA Charterholder, runs her own financial planning firm, Stevens Portfolio Design, and manages over $100 million in assets.

The concern is what to do with the property when it is again time to pass it on to the next generation. What would be the best way to create a perpetual entity for the beach property? I have suggested they consult a qualified real estate attorney. I'd appreciate any insight you may have.

What you really need is a good estate attorney. Since that’s not what I am, I called on Bernie Wall of Carroll & Wall in Chicago to get some ideas. Bernie suggested that if the arrangement is to run in perpetuity, the interest should be controlled in an entity that is exempt from GST tax (generation-skipping tax). "To avoid additions to an exempt trust from contributions by beneficiaries for maintenance and other items," Wall said, "it is probably best to put title in either a corporation or LLC which can continue in perpetuity and then hold that interest in a trust to which GST exemption is allocated. As a result, there will not be estate or GST tax as the various beneficiaries pass away."

You also have to consider who has control. Someone has to make decisions about when people get to use the property, how it is maintained, and so forth. This may start out to be manageable, but can get quite complicated over time. "The trustees ... would control the corporation or LLC," said Wall. "Perhaps there could be one trustee from the two family lines with a tie-breaker provision if they do not agree."

Further, you need to think about what would happen if someone now or in the future wants to sell the property. "There should be some mechanism to permit a sale or a buyout of a family line that no longer wants to participate."

My best advice: Find a good estate attorney and talk through these issues with him or her. One place to look for an attorney is www.lawyers.com. Look for a "Trusts and Estate" attorney in your area.

Dear Sue,

I currently have two bond funds in my IRA: Vanguard Total Bond Market Index and Vanguard TIPS. I am looking to further diversify my bond portfolio, but I don't know which types of bond funds to add. Maybe an international bond fund? I also saw in one of your articles that you believe that a GNMA fund should be added. Why is this? Lastly, I was thinking about adding a convertible bond fund, but these funds seem to act more like equity funds. What do you think?

I completely agree that you should be thinking about diversifying your bond holdings. You are already in two of my favorite bond funds:  Vanguard Total Bond Market Index  and  Vanguard Inflation-Protected Securities . If you look at the holdings of the former, you'll see 70% is invested in Treasuries and agency bonds and no junk bonds (those rated BBB or worse). Inflation-Protected Securities, meanwhile, is 100% government bonds, so you currently have no high-yield (or junk bond) exposure. You could allocate a portion of your bonds to a fund like  Vanguard High-Yield Corporate , but I would probably limit that move to 10% of your portfolio.

You may also want to consider some other types of bond funds.  Fidelity Floating High Income  invests in bank loans, so its returns generally rise with interest rates.  T. Rowe Price Spectrum Income  is one of Morningstar's Fund Analyst Picks in the Multisector Bond category.  T. Rowe Price International Bond  is also a good selection for its category.

I do think international exposure in bond funds can broaden your diversification--similar to international exposure in the stock world. I would probably stay away from strict convertible bond funds right now because it’s becoming more difficult to find opportunities in this sector (see  "Our Favorite Convertibles Funds"). Finally, you personally don't need a GNMA fund because you already have plenty of exposure to mortgage-backed bonds with Vanguard Total Bond Market.

Dear Sue,

When you buy an annuity, are you getting locked into the current interest rate? If so, would it be better to wait for interest rates to rise before buying?

It all depends on the type of annuity you're talking about. There are fixed annuities and variable annuities. A fixed annuity is based on a set interest rate, while a variable annuity lets you choose the underlying investments (a mix of bond funds and stock funds). There are also immediate annuities (which start paying immediately) and deferred annuities (which pay in the future). The type of annuity to consider will be determined by your own particular circumstances. Be sure to consider all expenses if you decide to purchase an annuity.

So, to answer your question, if you're talking about fixed, immediate annuities, then yes, you are locking in the current interest rate. Even though rates are relatively low now, that still might be the "right" answer if you want to set up a future stream of income.

If you don't need to "annuitize" (start the regular stream of payments) right away, you may be better off with a variable annuity, which will allow you to choose the underlying investment. You can choose a fixed-income investment if you want that sort of stability and return. You can make periodic withdrawals (not locking in an annuity stream of income) from most variable annuities. You can also elect to annuitize your variable annuity at a future date, perhaps when interest rates are higher. When you do decide to annuitize, you won't necessarily get the current rates. The actuaries will determine the rate to use based on a variety of factors.

Dear Sue,

It was my understanding that people who participate in a 401(k) plan, are not allowed to contribute to an IRA in the same year unless they have a fairly low combined income for the year--somewhere around $30,000 or less for a married couple. Am I mistaken?

Yes and no. If you are talking about a traditional IRA, you are correct. If it's a Roth IRA in question, you're incorrect.

With a traditional IRA, if you participate in a 401(k) plan and your married filing joint-modified AGI (adjusted gross income) is over $75,000 ($55,000 for singles), you can't make a deductible contribution. You can, however, make a non-deductible contribution to a traditional IRA. If your spouse is not working, he or she may be able to make a deductible traditional IRA contribution if the married filing joint AGI is not over $160,000.

With a Roth IRA, both spouses can make contributions (although neither is deductible) unless married filing joint income is above $160,000. The benefit to making a non-deductible Roth IRA contribution is that once you're older than 59.5 years (and have been in the Roth IRA for at least five years), all withdrawals are tax-free.

For more on IRA rules, see Publication 590 at www.irs.gov.

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Sue Stevens, CFA, CFP, CPA has a position in the following securities mentioned above: VIPSX Find out about Morningstar's editorial policies.
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