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Options Aren’t an Option for Most Stock Funds

Q: Are there mutual funds that invest solely in stock options? What are their names? --R.S.

A: What are you, some sort of gambler? No, we couldn’t find any funds exactly like those you describe.

A likely reason is the “short short test.” As you may know, mutual funds themselves do not pay income taxes on their gains, but rather pass the gains through to investors who are then responsible for settling with Uncle Sam.

For mutual funds to retain this “pass-through” tax status, the IRS requires that no more than 30% of a mutual fund’s annual earnings be from investments held less than three months. Thus, the short short test. As you probably also know, option trading is not for the long term, and many investors measure their holdings in terms of hours and days, not months and years.

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A fund dealing solely in stock options would not be for the faint of heart. But maybe you’re really asking about a type of mutual fund known as “option income funds.” These funds--there are just a few--are quite different. Rather than buying options on stocks, these funds sell options on stocks they hold. By selling these “covered calls,” the funds hope to generate additional income and boost yields.

Here’s how it works: A call option is the right to buy a stock at a specific price on a specific date. The option buyer pays for the right, hoping that on the exercise date the stock will be worth more on the open market. If the investor is right, he buys stock from the option seller at a bargain price; if he’s wrong, the seller pockets the investor’s premium as income.

The strategy can be a winning one for a mutual fund, particularly when the stock market is drifting in a narrow trading band. However, when the market is rising, the option seller is at risk of having to sell shares at below-market prices.

Just 13 of the more than 1,100 mutual funds available in the United States write covered calls, and according to one industry group, their overall performance for the last five years has not kept pace with the rest of the funds’.

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How to Handle 401(k) Lump-Sum Payment

Q: I will soon get a lump-sum distribution of $200,000 from the 401(k) plan of my previous employer. Since this sum is larger than federal insurance coverage limits for a single account, may I divide the money among several individual retirement accounts? Also, about $25,000 of this account is after-tax contributions. May I withdraw this money now to ensure that it is not taxed again when I distribute my IRAs? --G.R.

A: You may open as many IRAs as you want to handle your 401(k) distribution. But federal rules require that you withdraw the $25,000 of after-tax contributions you made to the 401(k) before you roll the remainder of the account into one or more IRAs. There is no penalty for this distribution because you already paid tax on the money before you put it into the 401(k) account.

Contributing to Your Keogh After Age 70

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Q: I am aware that the first distribution from a Keogh plan must be made by April 1 of the year after the year in which I turn age 70 1/2. If I am still working, can I continue to make contributions while taking distributions? --S.A.H.

A: Yes. You may make contributions for as long as you work. But because your contributions continue, you will be required to recalculate the amount of your annual distributions based upon those additional contributions. Your calculations should be based on the amount in your Keogh as of Dec. 31 of the year proceeding the distribution.

This Bond Legacy Poses Taxing Problem

Q: I inherited U.S. Savings Bonds from my parents when they died and I would like to cash them. Do I pay tax on the interest or is the interest part of the estate, which was already taxed?-- W.J.J.

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A: We must assume that your parents did not pay taxes on the interest as it accumulated. This is the most common practice among savings bond holders.

Inherited income such as accumulated interest is potentially subject to estate taxes and income taxes. However, the government taxes this income only once.

So let’s assume that you inherited a $5,000 bond that was worth $7,500 at your parents’ death. The bond’s basis is $5,000 and the interest is $2,500. As the heir, you are responsible for paying taxes on the $2,500. However, if the entire bond was subject to estate taxes, you can claim a deduction for any estate tax paid on the $2,500 interest. So you have to pay the piper only once.

Income Averaging on Retirement Account

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Q: I plan to take early retirement when I reach 55 this year. My account in the company savings plan will be worth about $270,000. Since I don’t need the money at this time, I plan to leave the money in my company account on a tax-deferred basis, rather than rolling it over into an individual retirement account or taking a lump-sum distribution. But when I do close my account at the company sometime in the future, will I still be eligible for five-year income averaging on the proceeds? Or do I have to take the money now to take advantage of that benefit? --D.W.P.

A: If the five-year income averaging provision is still a part of the tax code when you take a lump-sum distribution from your company plan, you can certainly take advantage of it. However, there is nothing to guarantee that this provision will still be in effect. And there’s nothing in the works to indicate that it won’t be. You should simply realize that you may be taking a calculated risk. Given the size of your company savings account, you may want to consult a qualified financial planner, tax lawyer or accountant.


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