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June 2012: ACap ReCap

June 2012 ACap ReCap:

1. I am overwhelmed with student loans, the different types, their names, and the confusing terms. How can I simplify my student loan situation? What are my options?

This is by far one of the most commonly asked questions I receive, especially among residents, fellows, and early career doctors. Students are graduating with more college debt than ever before and from various lenders. If you include graduate school (i.e. medical, business, or law school), student loans can easily exceed six figures. Given that this concern is felt by so many people, I have written an entire article that breaks down each type of student loan and explains how to consolidate or apply for a lower payment plan. Click here to read related article.

2. I just inherited an IRA from my father’s estate. Can I combine this with my IRA?

No, you cannot combine the IRA you inherited from your father with your personal IRA. In fact, you have to start withdrawing money from that inherited IRA beginning the year after your father’s death. Also, the distributions from the inherited IRA are included in your taxable income. You can transfer the inherited IRA without a tax penalty to another custodian to manage the inherited IRA for you, but you cannot make additional contributions to the inherited IRA. Note that the rules for inherited IRAs vary depending on the relationship to the deceased (i.e spouse, parent, other). For example, if the IRA beneficiary was a spouse, the surviving spouse can treat the inherited IRA as if their own and he/she would not be required to take distributions.

3. What is a stretch IRA?

This was not one of the most commonly asked question this month, but given it’s connection to question number 2 and it’s limited familiarity among the general public, stretch IRAs warrant an explanation. A stretch IRA is simply any IRA whereby the beneficiary is a very young person. A stretch IRA is a great way to transfer wealth to future generations efficiently and at no cost. If you inherit an IRA from a non-spouse, you are required to begin taking minimum distributions based on your life expectancy (the IRS has a table you must use).  However, the younger you are, the longer your life expectancy, and the less you have to take out each year. By naming young grandchild or another young child as a beneficiary, you essentially stretch the growth of that IRA for a much longer time. For simplicity, assume at age 40, you inherit a $100,000 IRA from your father. According to the IRS table, you would have to begin withdrawing $2,294 ($100,000 / 43.6) or 2.3 percent of the portfolio the first year. However, if your 1-year old son inherits the $100,000 IRA from your father, he would have to begin withdrawing only $1,225 ($100,000/81.6) or 1.2 percent of the portfolio the first year. If the portfolio earns more than 1.2 percent, the rest can stay in the IRA.

4. The Federal Reserve has lowered rates to nearly zero, so why are mortgage rates still above that?

Many people wrongly assume that the Federal Reserve controls mortgage rates when they set interest rates. Until recently, the Fed controlled interest rates using only two levers: the Fed Funds rate and the Discount Rate. The Fed Funds Rate is the rate banks charge to each other for overnight loans, whereas the Discount Rate is the rate charged by the Fed to member banks for borrowing from the Fed. Home mortgage rates are actually determined by the bond market; specifically, the U.S. 10-year Treasury Bond and mortgage backed securities (MBS). Most bonds are tied to the U.S. 10 year Treasury bond because it is deemed to be a risk-free asset, and investors demand an interest rate premium (called a spread) on all other bonds based on their perceived risks. I say until recently because the Fed began buying all types of financial instruments, including mortgage backed securities, during the financial crisis to maintain liquidity in those assets, and in some cases, artificially keep mortgage interest rates low.

5. What is a REIT and how is it different from a stock?

A Real Estate Investment Trusts (REITs) is a fund that invests primarily in income producing real estate such as apartment buildings, skyscrapers, strip-malls, office buildings, etc. REITs are a great way to diversify one’s portfolio because they don’t always move in the same direction as stocks and bonds, and because REITs are a good hedge against inflation since rents tend to rise with inflation. REITs collect rent from their properties and are required by law to distribute at least 90 percent of their taxable income to their shareholders – as a result, REITs usually have a high yield. There are two types of REITs: equity and mortgage. Equity REITs own and manage the properties and their income comes from the rents received. Mortgage REITs do not own real estate, rather, they buy and manage real estate loans so their income is derived from people buying their mortgages.

Ara Oghoorian, CFA, CFP® is the president and founder of ACap Asset Management, Inc., a “Fee-Only” investment management firm located in Los Angeles, CA specializing in helping doctors and physicians make sound financial decisions. Contact Ara at aoghoorian@acapam.com or on the web at www.acapam.com for a complimentary consultation.