Questions and Responses

Is it advisable to buy a fund in a variable annuity wrapper?

Can I get back the tax I paid for an early IRA distribution?

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What are the benefits and drawbacks of investing in new mutual funds?

from John

A: (Frank)  Unless a new fund represents an entirely new asset class that you would like to invest in, I'm unaware of any advantages. There are plenty of good known funds out there. Last time I looked, Morningstar tracks over 11,600 non money market funds! It's really unlikely that a new fund is going to be able to find an idea that hasn't been tried before.

On the other hand, there may be potential problems. Not every fund will have any or all of the following, but why take the risk? 

New funds may have higher expenses because they can't spread the fixed costs as well as larger funds. Expenses come right out of your pocket. 

New funds may not survive. A fund liquidation could spell tax problems and result in time out of the market and re-investment costs. If the fund is merged with another fund, you may end up in a much different type of investment than you started out with. At very best, such an event would be aggravating.

New funds may take extra risk in order to get noticed. Fund managers know that a big performance early on might generate huge positive cash flows. Being number one or two in a category drives cash to funds and enriches the fund sponsors. To the extent that managers might be tempted to swing for the fences to enhance their own compensation, there may be a conflict of interest. The extra risks of concentrated portfolios and/or frantic trading are not compensated (on average) by additional return .

Unless you had a compelling reason to purchase a new fund, I would suggest that you pass.

Is it advisable to buy a fund in a variable annuity wrapper

from Tan

Q: I bought a Janus Mutual Fund recently through American Skandia rather than buying directly from Janus. What are the pros/cons of doing so?

A: (Frank)  There is a huge difference between a variable annuity like American Skandia, and a no-load mutual fund like Janus. Putting the fund inside an annuity wrapper changes everything.

In general terms, when it comes to annuities, investors should just say "NO".

For starters, you got to pay about a 7% commission to the agent. While you don't see it come out of your account right away, you will have to pay annual fees about 1.4% higher than the mutual fund would be by itself. Those fees typically go on forever. Big differences in cost will add up to HUGE differences in accumulation over a few years.

Selling the annuity before the insurance company recovers all the commission will generate a "contingent deferred sales charge" which is a confusing way to say back end load.

When you take the money out, what could have been capital gains will be ordinary income. For most of us, that's almost twice as much tax to pay. 

If you die while you hold the annuity, your heirs will get to pay income tax on the gains. An annuity is one of the few assets you could hold that doesn't get a step up in basis at death. If you had held the fund, any appreciation is forgiven by Uncle Sam. The income tax is in addition to any estate tax that your might have to pay.

If you would like to know more about annuities, I recently wrote a multi-part series on annuities published here at MFI. See: http://www.brill.com/funds101/arm09003a.html.

Can I get back the tax I paid for an early IRA distribution?

from Christine

Q: Several years ago, I had to take $16,000 out of my IRA to pay medical bills and live on a limited budget. I did not report this additional income to the IRS as I didn't know it was taxable. the IRS sent me a letter saying I owed approximate $2,200--including penalties. to pay that off, I took more money out of my IRA. I now realize that my medical expenses could have been an exception to the early distribution tax. What do I do to get my money back? 

I'm in desperate financial straits. I am 41 years old.

A: (Sid)  You can only deduct the amount that exceeds 7.5% of adjusted gross income (AGI).  This amount qualifies for relief from penalty for early withdrawal but there is not relief from regular income taxes since the distributions from the IRA qualify as regular income.

Medical expenses would offset income, therefore, reducing the income tax liability under your scenario to zero, assuming you had no other income.

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