Q. Here is my dilemma.  J.P. Morgan, without informing us first, has sent a check to my wife for the amount that was in her 401k with a previous employer. From this check they removed the penalty for early withdrawal.  She never requested the check, and when we called JP Morgan they informed us they could do a sweep of all accounts below $5,000 and close them out.

No prior written documentation informing us of this is available.  Essentially she has forfeited the penalty they removed, $768.  Additionally we will have to report the $3,000 plus that is in the check as income unless it is rolled over within 60 days.

This seems terribly unfair considering that was money she put into the account, and there was no prior notification.  Is there some retribution for this?  Will any of president Bush's plans to overhaul 401k plans take this into account?  Is this just a scam by the managing companies of 401k plans to gain back money lost over the course of the past two years?

---J.B., by e-mail

 

A. They may have been heavy handed but it's no scam. Cashing you out is legal under ERISA and the money withdrawn was added to your withheld taxes. Fortunately, there is a way you can avoid any loss--- but you'll need to take action and come up with some cash.

Brooks Hamilton, a Dallas benefits attorney, explained that J.P. Morgan had exercised the "Involuntary Cash-Out Limit" which was just raised from $3,500 to $5,000. If an account has more than $5,000, distributions can't be made prior to normal retirement without the participants' approval.

Mr. Hamilton explained that there are three things you can do:
  • You can do nothing. If you do that you will be liable for a 10 percent penalty for distribution plus income taxes on the entire distribution. The $768 withheld will count against the total tax and penalty liability.
  • You can do a timely "rollover" of the remaining money. If you do that the $768 that the plan Trustee paid directly to the Internal Revenue Service will be part of your tax withholding when you do your 2002 tax return. The amount rolled over will be not incur any income taxes because it will still be in a qualified plan. Unfortunately, the $768 withheld will still be subject to the penalty and tax because it was distributed.
  • You can add $768 to the check from J.P. Morgan and roll the entire sum into the new account. This will avoid all penalties and taxes. The amount withheld would be counted as taxes withheld. It could come back to you as a refund.


 

Q. Do you consider being 50% invested in Vanguard's S&P 500 Index Fund, and 50% invested in Vanguard's Total Bond Index Fund (or another bond fund) a fully hedged position?  Why or why not? Do you consider any percentage combination of these funds a fully hedged position?  Does the opportunity exist to be able to achieve a fully hedged position using any combination of funds within any family of funds? If so, what funds?

You often mention the S&P 500 Index Fund as a main component of the Couch Potato Portfolio, but you do not mention the Total Stock Market Index Fund as an alternative to the S&P 500 Index Fund in the couch potato portfolio. Since the total stock market index offers greater diversification than the S&P 500 index, why is this not a better fund for the couch potato than the S&P 500?  How have their returns compared over the last 15 years?

----S.R., by e-mail

 

A. Let's start with a definition of the word "hedge." According to the Dictionary of Finance and Investment Terms it means a "strategy used to offset investment risk. A perfect hedge is eliminating the possibility of future gain or loss."

When we add a fixed income investment to an equity portfolio our hedge is very limited. Instead, we are trying to reduce portfolio volatility and risk. There are, however, times when a fixed income investment is a good hedge: after the October 1987 market crash interest rates fell so much that many investors gained as much in their bond portfolios as they lost in their stock portfolios. In that sense they were hedged.

Over the last year and three-years the Total Market Index fund has done better than the 500 Index fund. Over the last 5 years, the 500 Index fund has done better. Over the very long term we should expect the Total Market Index to do slightly better than the 500 Index fund. Vanguards' Total Market Index fund has been in operation for nine years, so we don't yet have a 15-year operating measure of relative performance. Stay tuned.