By LAUREN FOSTER | Barrons

It’s easy for trustees to botch their roles. Here’s how to avoid the common pitfalls.

Trust and estate planning often comes down to three questions: Who gets what? How do you minimize taxes? And, once a trust has been set up, who is in control? Unfortunately, it’s easy for a family to bungle any one of the three. That’s especially so if you don’t have a professional on board as a trustee. Here are the five most common mistakes of do-it-yourselfers, and tips on how to avoid them.

FAULTY RECORDS: Most states require trustees to provide regular accountings to the beneficiaries— not only the income beneficiaries, but also what are known as remaindermen, the family members down the line who will receive the principal once the trust has been dissolved. This means keeping comprehensive records of income, as- sets and distributions—and many trustees fall short of the mark. “This is probably the most mundane, and at the same time, the most troubling task for individual trustees,” says David A. Baker, a partner in law firm McDermott Will & Emery. The price of failure could be a big lawsuit later on by a beneficiary or remainderman.

Tip: Assemble a reliable outside team with a money manager, a trust lawyer and a tax pro.

By Lauren K. Keenan and Lori K. Murphy Bean

Recently, a couple came to our firm seeking assistance with basic business succession planning but it quickly became clear that they also needed to plan for their young daughter who suffers from a severe disability. The couple had two young children, one with special needs and one who was developing typically, and no existing estate plan in place to provide for their future care. The situation of a client seeking help on one thing (business succession) but needing something else more urgently (a special needs trust) isn’t uncommon in our line of work. Many people aren’t aware of the fact that if they transfer wealth to individuals with special needs, one must do so with great care and with the oversight of a team of experts who know which pitfalls to avoid and avenues to pursue in order to ensure that a special needs individual receiving an inheritance maintains eligibility for important government benefits.

According to the Wealth Counsel’s 4th Annual Industry Trend Survey, published in January 2011, one of the top ten reasons clients plan their estate is to provide for a special needs family member. In 2010, the U.S. Census Bureau provided data which calculated the total number of disabled individuals in the U.S. to be 54 Million, or 19 percent of the civilian, non-institutionalized population. According to the same data, five percent of children ages five to 17 are disabled…to continue reading, go to Transferring Wealth to Individuals with Special Needs/Mental Disabilities at Financial Advisor magazine.

BOSTON — When it comes to retirement, the average American age 65 and older generates nearly two-thirds of their total income from a combination of earned income and Social Security, with the rest coming from pensions and personal assets.

But despite the fact that millions are earning income and collecting at the same time, there’s still plenty of confusion over how Uncle Sam goes about taxing and reducing Social Security benefits for workers. Consider, for instance, some of the reasons why it can be confusing:

First, if you retire before the normal retirement age and start collecting Social Security benefits early, your benefits are reduced not only for starting early, but also as your earnings rise. In fact, if you work and collect before the so-called full retirement age, you’ll lose $1 of Social Security benefit for every $2 earned over $14,160 in 2011.

Second, in the year that you reach full retirement age, your benefits are reduced $1 for every $3 earned over $37,680 in 2011, or least that’s the case until the month you reach full retirement age.

Finally, once you’re at full retirement age, your benefits are not reduced, but as much as 85% of the benefits could be taxed if your income is above a certain amount.

According to the Social Security website, if you file a federal tax return as an individual and your combined income is between $25,000 and $34,000, you may have to pay income tax on up to 50% of your benefits. And if your combined income is more than $34,000, up to 85% of your benefits may be taxable. If you file a joint return, and you and your spouse have a combined income that is between $32,000 and $44,000, you may have to pay income tax on up to 50% of your benefits. And if your combined income is more than $44,000, up to 85% of your benefits may be taxable. If you are married and file a separate tax return, you probably will pay taxes on your benefits.

Even though all this might be confusing, there are some ways to increase your after-tax income from all your sources of income — be it earned income, Social Security, dividends, interest income, capital gains, pension income and the like. What’s more, there are some ways to think differently about the interaction between earned income and Social Security benefits.

At a recent MarketWatch roundtable discussion, two of the nations’ top retirement-planning experts offered tactics to consider to when deciding whether and how much to work in retirement, as well as whether and when to start taking Social Security benefits.

Read more: How to Collect Social Security and Keep Working

January 24, 2011 3:55 pm ET

When Helen Siswein, a retired teacher, heard about an investment that might earn 8 percent a year and never lose money, she was sold.

“I thought, ‘Boy, if the market surges I could make a lot,’” said Siswein, 82. She put about $1 million into four different annuities linked to stock-market indexes in July 2003 on the advice of an insurance agent who came to her former home in Bucks County, Pennsylvania, after her husband died.

Siswein said the agent didn’t tell her she was locking up most of her money until her 87th birthday or that there were caps on how much she could earn. It cost Siswein fees of as much as 15 percent of her account balances to get out of the investments five years later, the contracts show. She says one annuity earned an average of about 3 percent a year after the penalty was subtracted, while the index it tracked, the Standard & Poor’s 500 Index, returned 6.3 percent including dividends.

Investors such as Siswein are buying more equity-indexed annuities, contracts that earn money based on the performance of stock indexes and don’t decline in value if held to maturity. While that protection may be attractive to investors who saw the S&P 500 plunge 38 percent in 2008, the contracts’ complex terms and embedded fees make them unlikely to perform as well as expected, said Kent Smetters, a professor of insurance at the University of Pennsylvania’s Wharton School.

“These contracts have really high hidden fees,” said Smetters, a former U.S. Treasury Department economic policy official. “That’s why they’re terrible ideas for older people even though they’re peddled to them.”

Record Sales of Indexed Annuities

Insurers led by Allianz SE and Aviva Plc sold a record $8.7 billion of indexed annuities in the third quarter, up 16 percent from a year earlier, according to AnnuitySpecs.com, a market research company. The contracts generally earn nothing when stocks fall and include caps on returns that insurers can change at will. Salespeople are paid commissions as high as 12 percent, and some are rewarded with free trips to Disney World. Unlike the fees on mutual funds, those costs aren’t disclosed.

Indexed annuities are part of a boom in structured products, opaque investments pitched as a way for conservative investors to earn higher yields. As insurance agents sell more complex annuities, stockbrokers across the country are pushing structured certificates of deposit and notes, which are similar derivatives-based investments created by Wall Street banks. Sales of structured notes rose to a record $49.5 billion in 2010, according to data compiled by Bloomberg.

“The pure psychology of downside protection with upside potential sells really well,” said Smetters. “These products are all very complicated. The problem is, they’re not transparent.”

Use of Derivatives in Indexed Annuities

Salespeople typically downplay the complexity of indexed annuities and their long lock-up periods, said Barbara Roper, director of investor protection for the Consumer Federation of America, a Washington-based lobbying group. The contracts are “one of the most abusively sold products on the market today,” said Roper.

Insurers create the annuities using derivatives, financial contracts whose value is derived from stocks, bonds and commodities. While the policies guarantee principal if held to term, they have withdrawal penalties that may last for more than 10 years. The dividends paid by stocks in the index generally aren’t counted toward the annuities’ returns. Buyers can convert the contracts into a lifetime stream of income at maturity. Most don’t, said Smetters.

Downside Protection of Indexed Annuities

“You will never get all of the upside” of the stock market because returns are capped, said Eric Thomes, senior vice president of sales at Allianz Life Insurance Company of North America in Minneapolis, the largest seller in the U.S. “You also don’t need to worry about the downside, and with what happened in 2008, this type of benefit will no doubt interest a lot of people.”

Low yields on federally insured bank CDs are helping sales of indexed annuities, said Wendy Waugaman, chief executive officer of American Equity Investment Life Holding Co., based in West Des Moines, Iowa.

“It’s really easy to see why they’re so popular in today’s environment,” said Waugaman. Investors also are buying because they’re “afraid of market risk,” said Waugaman. American Equity is the third-largest seller of indexed annuities, according to AnnuitySpecs, based in Des Moines, Iowa.

Disney World for selling Indexed Annuities

The company is offering agents that sell at least $2.5 million of its products in the 12 months ending June 30, 2011, a trip to the Walt Disney World resort in Orlando, Florida. Agents must sell an additional $600,000 of annuities to bring a child. The trip is to the firm’s annual convention, a standard industry practice, said Waugaman.

Insurers who sell indexed annuities buy derivatives from banks to cover the contracts’ guarantees, making the business less risky than selling other investments with a guaranteed minimum return. In 2008, insurers lost money on variable annuities with similar guarantees when the stock market plummeted. Hartford Financial Services Group Inc. wrote down the value of a variable-annuity business by $274 million and Prudential Financial Inc. also recorded a loss.

Indexed annuities tend to underperform a lower-risk strategy of rolling over CDs, “because of the high cost embedded in these things,” said William Reichenstein, professor of investments at Baylor University in Waco, Texas.

CDs Are Better

For example, an insurer may take $100 from a customer and invest $94.33 of that in bonds and keep $2, said Reichenstein, who has analyzed several indexed-annuity contracts. With that remaining $3.67, the company buys a portfolio of derivatives linked to the S&P 500 that will give investors some, though not all, of the index’s returns.

Even with interest rates near record lows, CDs may still do better than the annuities because insurers will have to reduce caps on returns to maintain profitability, Reichenstein said.

“They’re not playing Santa Claus,” said Reichenstein. Insurers must earn enough over time to recoup what they pay upfront to agents or brokers who sell the annuities, cutting into returns to investors, he said. Commissions range from 1.5 percent to 12 percent, according to AnnuitySpecs.

The opacity of the products’ fees and complexity of the return calculations makes it impossible for investors to figure out if they’re getting a good deal, said Glenn Daily, a fee-only insurance consultant based in New York.

“You’re paying the insurance company to set up and manage a portfolio of fixed-income securities and derivatives,” he said. “You don’t have transparency.”

Surrenders, Withdrawals of Indexed Annuities

Contracts prevent canceling, or surrendering, for a refund of the account balance without a penalty for a set period that ranges from 3 years to 16 years, AnnuitySpecs data show. However, most contracts do permit 10 percent penalty-free withdrawals annually, according to AnnuitySpecs. Owners may incur a 10 percent charge from the Internal Revenue Service if distributions are made before age 59 1/2 because the earnings are tax-deferred.

Siswein, the retired teacher, bought her indexed annuities from Robert Calamunci of Monmouth, New Jersey. Calamunci, now an accountant, said he no longer sells the products and declined to comment further. Siswein said she needed financial advice after her husband’s death left her with more assets to manage and Calamunci convinced her to put about $250,000 each into four indexed annuities.

For the rest of this article and its points on “total return,” excessive fees, additional spreads taken by insurance companies and the lack of FDIC Insurance go to Indexed Annuities ‘terrible idea.”

Retirement Dollar

The need for retirement planning doesn’t end with the onset of retirement. A new retiree’s focus shifts from building wealth to managing and preserving it. One major challenge is to make the investment portfolio supply cash flow for the duration of life—and through different economic and market conditions.

Experts have studied portfolio longevity or endurance to help retired investors reduce the odds of depleting their wealth too soon. The studies evaluate how a portfolio might endure under the stress of changing markets and spending levels. The resulting models estimate portfolio survival in terms of statistical probabilities.1 While the technical details are beyond the scope of this article, the general conclusions are more intuitive.

Three main factors drive portfolio endurance: asset mix, spending level, and investment time frame. Certain aspects of these factors are within an investor’s control while others are not. Let’s briefly consider them.

Asset Mix for Retirement

Asset mix describes the ratio of stocks to bonds in a portfolio. This determines risk exposure and expected performance, and is one of the most important decisions investors of all ages can make. Historically, stocks have outperformed bonds and outpaced inflation over time. This return premium reflects the higher risk of owning stocks.2 Consequently, the larger the equity allocation, the greater a portfolio’s expected return—and risk.

Keep in mind that risk and return go together. A higher allocation to equities increases the risk of experiencing periods of poor returns during retirement. But if you can handle the risk, having more equity exposure in a portfolio enhances its return potential. Growth can bring higher cash flow, inflation protection, and portfolio endurance over time. This is why most advisors believe that most investors should have an equity component in their portfolios, with actual weighting depending on one’s time frame, risk tolerance, and spending flexibility.

Spending Level During Retirement

Portfolio withdrawal is typically described in terms of a specified dollar amount (e.g., $50,000 per year) or a percent of annual portfolio value (e.g., 5% of assets each year). Neither method is ideal, however—and for different reasons. Briefly consider each one:

•    Specified dollar amount:  withdrawing a fixed amount each year and adjusting it for inflation can provide a stable income stream and preserve your living standard over time. But the portfolio may survive only if future withdrawals represent a small proportion of the portfolio’s value. One academic study quantified this amount. It found that a retiree with at least a 60% stock allocation can withdraw up to 4% of initial portfolio value (adjusted for inflation each year), and enjoy a high probability of never running out of wealth.3 Choosing a higher withdrawal amount is not likely to be sustainable, especially if the portfolio faces an extended period of negative returns.

•    Percent of annual portfolio value: withdrawing a fixed percentage of assets based on annual asset value makes it unlikely that you will deplete retirement assets because a sudden drop in market value would be accompanied by a proportional decline in spending. But this method can produce wide swings in your living standard when investment returns are volatile.

Retirees who need relatively consistent cash flow may want to combine these two methods. One way is to withdraw cash flow according to a rule that combines past spending (e.g., an average of the past thirty-six months of cash flow) with a payout rate applied to current portfolio value. You can weight these factors to favor your preference for either more stable cash flow or a greater chance of portfolio survival. In effect, you are customizing your withdrawals to smooth out consumption while responding to actual investment performance.

Investment Time Frame for Retirement

Investment time horizon may be the hardest to estimate, especially if it is the same as your lifespan. In this case, you can only guess how long your portfolio must support spending. If you plan to bequeath assets, your investment time frame may extend beyond your lifetime. This may influence your risk and spending decisions as well.

Time frame forces a tradeoff between the short and long term. Retirees with a longer investment time horizon might choose a higher exposure to equities. But they may have to offset this risk by being more flexible about spending over time. Elderly retirees and others with a short time horizon may choose a less risky allocation or a higher payout rate, although they can experience rising spending levels, too. In any case, retirees should think carefully about equity exposure and avoid taking more risk than they can afford.

Considerations During Retirement

Planning involves assumptions about the future—assumptions that may not pan out. Although you cannot avoid making assumptions, you can ask whether they are realistic and consider how your lifestyle might change if future economic and financial conditions are much different than projected. For instance, you may assume an average return based on historical performance. But there is no certainty that future portfolio returns will resemble the past, regardless of time frame. Moreover, short-term results may vary drastically, which could force hard financial choices. Investors should think in terms of probability, not history.

Managing asset mix, payout, and time horizon inevitably involves tradeoffs. Exhibit 1 below illustrates the dynamics. For example, a bond-dominated portfolio with a lower expected return may suit investors with a shorter time horizon, or require them to accept a lower payout rate to increase the odds of portfolio survival. A portfolio with a higher allocation to equities may be appropriate for someone with a long time horizon or a strong desire for a high payout rate, but a higher assumption of risk also results in greater uncertainty about future wealth. Retirees who take this route must be able to handle the risk emotionally, and they should be ready to adjust their lifestyle in response to market downturns. In fact, investor flexibility plays a role in all of the tradeoffs.

Basic Trade-offs in Portfolio Survival

Finally, although you cannot fully control these and other factors involved in portfolio endurance in retirement, having more wealth can improve the odds of having a less stressful financial life. A more substantial nest egg might enable you to take fewer risks, enjoy a higher sustainable spending rate, or extend the productive life of your portfolio during retirement.

__________________________________________

Endnotes:
1 Cooley, Philip L., Carl M. Hubbard, and Daniel T. Walz. 1998. “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable,” AAII Journal 20: 16–21. Also see: Bengen, William P.  1994. “Determining Withdrawal Rates Using Historical Data,” Journal of Financial Planning 7: 171.

2 From 1926 to 2009, the S&P 500 Index returned an average 9.8% per year compared to 5.4% for long-term government bonds and 3.0% inflation. Sources: Standard & Poor’s Index Services Group for S&P 500 Index; long-term government bonds and inflation provided by Stocks, Bonds, Bill, and Inflation Yearbook™, Ibbotson Associates.

3 Cooley, Hubbard, and Walz, Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable,” 16–21.

This article was provided by Dimensional Fund Advisors. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

Planning allocations between entities and beneficiaries is even more critical with higher tax rates on the horizon.

By Sonja Pippin, Ph.D. – Journal of Accountancy

New tax laws will have a significant impact on the taxation of trusts. If you, or someone you know, is acting as trustee to an irrevocable trust, then you need to pay attention to this article.

Estates and nongrantor trusts must file income tax returns just as individuals do, but with some important differences. For one, their income is taxed at either the entity or beneficiary level depending on whether it is allocated to principal or allocated to distributable income, and whether it is distributed to the beneficiaries. And because their exemption amounts, tax brackets and related thresholds haven’t been indexed for inflation or modified for tax relief to the extent those for individuals have, they can be subject to higher tax rates at much lower levels of income. With the new Medicare tax on investment income on the highest tax brackets, estates and trusts pay still more taxes on incomes over $11,200, as opposed to $200,000 or $250,000 for individuals.

In this and other ways, the Patient Protection and Affordable Care and the Health Care and Education Reconciliation acts of 2010 (PL 111-148 and PL 111-152, respectively) affect trusts’ and estates’ income taxes and have introduced discrepancies that tax practitioners can review with their clients who administer trusts and estates. This article reviews some strategies for more tax-efficient allocation of income and principal by trusts and estates.

For the complete article, go to Income Tax Accounting for Trusts and Estates in the Journal of Accountancy

America’s baby boomers—those born between 1946 and 1964—face a problem that could weigh on the economy for years to come: The longer it takes for the economy to recover, the less money they’ll have to spend in retirement.

Policy makers have long worried that Americans aren’t saving enough for old age. And lately, current and prospective retirees have been hit on many fronts at once: They have less money, they earn less on what they have, their houses aren’t rising in value and the prospect of working longer to make up the shortfall has dimmed significantly in a lousy job market.

“We will have to learn to make do with a lot less in material things,” says Gary Snodgrass, a 63-year-old health-care consultant in Placerville, Calif. The financial crisis, he says, slashed his retirement savings 40% and the value of his house by about half.

Banks, home buyers and bond issuers are all benefiting as the U.S. Federal Reserve holds short-term interest rates near zero to support a recovery. But for many of the 36 million Americans who will turn 65 over the next decade—and even for the 45 million who have another decade to go— the resulting low bond yields, combined with a volatile stock market, are making a dire retirement picture look even worse.

Low yields present retirees with a difficult choice: Accept the lower income offered by safer bonds, or take the risk of staying in the stock market. Either way, their predicament could put a long-term damper on the consumer spending that typically drives U.S. growth.

“If these rates stay as low as they are, then a lot more people are going to be hurting,” says Jack Van Derhei, research director at the Employee Benefit Research Institute. The non-partisan outfit estimates that if current conditions persist, nearly three in five baby boomers will be at risk of running short of money in retirement. “There are going to be many luxury items that will simply have to be eliminated,” for retirees to make ends meet.

Despite the market’s rebound from the lows of 2009, nest eggs remain severely impaired. As of the first quarter of 2010, net household assets—homes, 401(k) plans, pension assets and other investments minus debts—stood at $54.6 trillion, down 18% from the end of 2007. That’s an average of about $171,000 per person, much of which is concentrated in the hands of the wealthiest.

At the same time, the return people can hope to earn on their assets has fallen, particularly for those who switch into bonds or annuities to guarantee a fixed income. The average yield on U.S. government, corporate and mortgage bonds stands at about 2.4%, while stock-market valuations suggest a long-term return of about 6%. At those levels of return, some 59% of people aged 56 to 62 will be at risk of not having enough money to cover basic living and health-care costs in retirement, estimates Mr. Van Derhei. If market returns are higher—8.9% for stocks and 6.3% for bonds—the picture isn’t a lot better: The percentage at risk falls to about 47%.

Before the recession hit, many economists assumed people would solve their retirement problems simply by staying in the work force longer. Now, “the recession has blown that idea out of the water,” says Alicia Munnell, director of the Center for Retirement Research at Boston College and co-author of a 2008 book that advocated working longer.

Older workers, who typically fared better than their younger counterparts in recessions, have been hit just as hard by layoffs this time around. As a result, the fraction of people 65 or older who are working has leveled off after a long period of growth. As of July, it stood at 15.9%, down from 16.3% in mid-2008.

For the rest of this article, go to the Wall Street Journal.