In the 21st century, the word “hybrid” is most readily associated with the ecological movement and most of us would agree that making the world a greener place is a worthwhile endeavor. However, “hybrid” can also apply to your personal economic movement in the form of structured notes, an investment vehicle that combines the growth potential of equities with the principal protection of a fixed income investment. Learn more about structured notes and the possible benefits of converting your traditional IRAs to Roth IRAs in this issue of MOR Investing.
This Hybrid Could Mean More Green For You
Nowadays, when you hear the word “hybrid,” investment products probably aren’t the first things to come to mind. In fact, you probably think of a car or SUV redesigned to help make the world a greener place. Lately, however, an increasing number of investors are turning to a hybrid security instrument as part of their investment plan to add more green to their portfolios. These unique securities, called structured notes, are designed to offer the growth potential normally associated with stocks or other asset classes yet preserve the value of your holdings in the face of market downturns. For investors looking to generate returns with a measureable level of principal safety, structured notes just may be what you are looking for.
Structured notes are often referred to as “hybrid” securities because while they retain many of the defining characteristics of debt instruments – including a fixed maturity term and a minimum principal value known in advance – the return component is linked to the performance results of a broad market index, such as the S&P 500 or the Dow Jones/AIG Commodity Index.
Appreciation and Protection
The primary appeal of structured notes lies in the ability to offer potential for capital appreciation while providing principal protection, even if the underlying index declines during the investment period. An example may help explain how issuers can create a principal protected security:
With a “pool” of $1,000 available to invest, our hypothetical issuer wishes to construct a portfolio that protects the principal value from losses but captures some of the performance of a stock index. To do so, the issuer would first purchase a zero-coupon bond that is scheduled to mature on the same date as the structured note. Zero-coupon securities are bonds that do not pay interest over the life of the bonds, but are purchased at a discount from the maturity value. By definition, the purchase price of the zero-coupon bond will be less than the maturity value, and the size of this discount will depend on the level of interest rates at the time of purchase. Continuing with the example, the issuer would purchase a single bond scheduled to mature in ten years at a cost of $650 and a maturity value of $1,000. After securing the “principal” portion of the structured note, the issuer uses the remaining funds (in this case, $1,000 minus $650, or $350) to invest in securities linked to the relevant stock index.
Assuming the zero-coupon security is held to maturity, the principal value of the original investment is secure, and any gains generated from the investment in the index are passed along to investors.
Because the return will not be fully known until the maturity date of the structured note, any income in excess of the defined principal value is not paid to structured noteholders until maturity. This is a noteworthy difference compared to “traditional” debt securities, which generally pay interest periodically over the life of the maturity.1
A Way to Gauge the Markets
As the investment universe has expanded in recent years, so too have the different asset classes. In addition to major equity indexes such as the Dow Jones Industrial Average, the NASDAQ 100, and the Standard & Poor’s 500 index, risk-averse investors seeking exposure to indexes that track the performance of commodities prices or inflation may do so using structured notes.
The specific terms of structured notes can vary significantly from one issue to another, and in addition to the method for determining the yield to investors, the terms of any call feature attached to a structured note should also be considered. Call options allow the issuer (but not the investor) to redeem the security prior to the stated maturity date. A call feature may limit the return that the investor receives when the related index performs well.
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Roth IRA Conversions--Planning for New Opportunities
With the lure of tax-free distributions, Roth IRAs have become popular retirement savings vehicles since their introduction in 1998. But if you're a high-income taxpayer, chances are you haven't been able to participate in the Roth revolution. Well, that's about to change.
In 2006, President Bush signed the Tax Increase Prevention and Reconciliation Act (TIPRA) into law. TIPRA repeals the $100,000 income limit for conversions to Roth IRAs, and also allows conversions by taxpayers who are married filing separately. What this means is that, regardless of your filing status or how much you earn, you'll be able to convert a traditional IRA to a Roth IRA. The bad news? This provision of the new law doesn't take effect until 2010.
So why concern yourself with this now?
Even though the new rules don't take effect until 2010, there are steps you can take now if you want to maximize the amount you can convert at that time. If you aren't doing so already, you can simply start making the maximum annual contribution to a traditional IRA, and then convert that traditional IRA to a Roth in 2010.
Your ability to make deductible contributions to a traditional IRA may be limited if you (or your spouse) is covered by an employer retirement plan and your income exceeds certain limits. But any taxpayer, regardless of income level or retirement plan participation, can make nondeductible contributions to a traditional IRA until age 70½. And because nondeductible contributions aren't subject to income tax when you convert your traditional IRA to a Roth IRA, they make sense for taxpayers contemplating a 2010 conversion even if they're eligible to make deductible contributions.
Consider the tax implications
If you've made only nondeductible contributions to your traditional IRA, then only the earnings, and not your own contributions, will be subject to tax at the time you convert the IRA to a Roth.
But if you've made both deductible and nondeductible IRA contributions to your traditional IRA, and you don't plan on converting the entire amount, things can get complicated.
That's because under IRS rules, you can't just convert the nondeductible contributions to a Roth and avoid paying tax at conversion. Instead, the amount you convert is deemed to consist of a pro-rata portion of the taxable and nontaxable dollars in the IRA. Also, the IRS makes you aggregate all your traditional IRAs (including SEPs and SIMPLEs) when calculating the taxes due whenever you take a distribution from (or convert) any of the IRAs.
But even if you have to pay tax at conversion, TIPRA contains more good news--if you make a conversion in 2010, you'll be able to report half the income from the conversion in 2011 and the other half in 2012.
As for employer retirement plans...
Before 2008, you couldn't roll funds over from a 401(k) or other employer plan directly to a Roth IRA unless the dollars came from a Roth 401(k) account or a Roth 403(b) account. The Pension Protection Act of 2006 has changed that. Now, you can simply roll over your employer plan distribution directly to a Roth IRA. You'll still need to meet the $100,000 income limit for 2009. And you'll still need to pay income tax on any taxable dollars rolled over.
One benefit of this new procedure is that you can avoid the proration rule, since you're not converting a traditional IRA to a Roth IRA. This can be helpful if you have nontaxable money in the employer plan and your goal is to minimize the taxes you'll pay when you convert.
Is a Roth conversion right for you?
The answer to this question depends on many factors, including your income tax rate, the length of time you can leave the funds in the Roth IRA without taking withdrawals, your state's tax laws, and how you'll pay the income taxes due at the time of the conversion.
Your Morgan Keegan financial advisor can help you decide whether a Roth conversion is right for you, and help you plan for this exciting new retirement savings opportunity.
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Important Messages for Account Holders
Securities purchased on margin are the firm’s collateral for the loan to you. If the securities in your account decline in value, so does the value of the collateral supporting your loan. As a result, the firm can take action, such as issue a margin call and/or sell securities or other assets in any of your accounts held with the member, in order to maintain the required equity in the account. It is important that you fully understand the risks involved in trading securities on margin. These risks include the following:
- You can lose more funds than you deposit in the margin account.
- The firm can force the sale of securities or other assets in your account(s).
- The firm can sell your securities or other assets without contacting you.
- You are not entitled to choose which securities or other assets in your account(s) are liquidated or sold to meet a margin call.
- The firm can increase its “house” maintenance margin requirements at any time and is not required to provide you advance written notice.
- You are not entitled to an extension of time on a margin call.
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