Tax Advantaged Investments
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Fixed Annuities
Variable Annuities
Municipal Bonds & Municipal Bond Funds
Universal/Variable Life Insurance
Tax Managed Mutual Funds
Growth Stocks
Individual 401k
Personal Home
IRAs / 403b / 401k
Reasons Novice Investors Fail
Basics of Investing
Fixed Annuities
Fixed-rate annuities are insurance contracts designed as retirement plans that work like a cross between a CD and a nondeductible IRA. A minimum premium of $2,500 or more is deposited with an insurance company where an investor enjoys safety of principal combined with a competitive, tax-deferred yield. The contracts can be purchased all at once through "single-premium" contracts, or over time through "flexible-premium" contracts. At some point the money in the account is withdrawn, either through periodic payments or in a lump sum, and the tax is paid.
A Single Premium Tax-Deferred Annuity is the right investment for a person who simply wants to defer income from tax until after age 59 ½ and who already has adequate liquid funds for short-term needs. Withdrawals of earnings from an annuity before age 59 1//2 are treated as ordinary income and are subject to a 10% early withdrawal penalty; unless the taxpayer is disabled, elects periodic distribution based on life expectancy, or meets other specified exceptions. One exception applies to distributions from an immediate annuity contract, which is a contract bought with a single premium under which substantially equal payments must begin within one year of purchase and continue over a designated period. Note: A taxpayer who originally purchases a deferred annuity contract cannot avoid the 10% penalty by switching that contract to an immediate annuity. Although the exchange of annuity contracts is tax free, distributions from the new contract are subject to the 10% penalty.
Interest earnings are always assumed to be withdrawn first and then principal; unless an annuity option is selected, in which case only a portion of each annuity payment will be taxable as ordinary income. Exception: Pre 8/13/82, annuity contracts retain the right to receive tax-free early withdrawals of investment in contract first (FIFO Method).
A deferred annuity is normally a good investment choice for a conservative, middle-income investor around 50 years of age who has all of his/her invested funds in CDs rather than in stocks and bonds; and who also does not want to risk the loss of principal if interest rates go up. Municipal bonds also may be a preferred investment alternative for investors who desire tax-exempt interest and have liquidity needs.
Fixed Annuity Advantages:
- Major advantage is deferral of taxes.
- Proceeds due beneficiaries are normally payable without the delay and publicity of probate. Beneficiaries can elect the payout option that is most tax advantageous.
- Provides supplementary retirement income. Many financial planners recommend deferred annuities for people around age 50 who generally have lower liquidity needs and who are thinking about retirement.
- Deferred annuities allow a taxpayer to keep current income below the threshold where Social Security benefits are taxed. In contrast, income from tax-exempt municipal bonds is included in the Social Security tax income computation.
- If the annuity is not fully taxable, a portion of each annuity payment is a nontaxable return of principal and a portion is taxablle
Fixed Annuities Disadvantages:
- Deferring taxes under current law may not be attractive if tax rates should rise sharply in the future when the taxpayer begins retirement income payments.
- 10% penalty on withdrawals before age 59 ½.
*CD's and other bank deposits are FDIC insured. Anuuities are not bank
deposits and not FDIC insured.
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Variable Annuities
A variable annuity bundles a collection of sub-acconts into a tax-deferred wrapper that functions much like an individual retirement account. Investors can switch money between funds without triggering taxes, and earnings grow tax deferred until withdrawn. The insurance component of the investment is a guaranteed death benefit. The insurance benefit is a guarantee to pay the value of the retirement account either at death or when the payment period starts, whichever is sooner. Most annuities pay at least the principal amount the customer invested over the years, even if the stock market wipes out the account entirely.
Variable Annuities are similar to Single Premium Deferred Annuities with the following differences:
- Risk: Variable annuities are riskier than fixed-rate annuities. However, they also present an opportunity for substantial appreciation of capital.
- Investment Flexibility: Funds are invested in one fund or among several stock, bond, or money market funds. Allocations can be made freely between funds without income tax consequences. An investor can move funds back and forth among the sub-accounts without incurring substantial trading costs.
- No Contribution Limits: Additional payments above the minimum can be made anytime.
- Guaranteed Death Benefit: A key feature of many variable annuities states that if death occurs prior to a certain age, beneficiary receives the greater of the amount invested (less any withdrawals) or the current market value of the account.
*Variable annuities are subject to mortality and expenses risk charges, administrative fees, etc. not typically found with other types of investments. Withdrawals prior to age 59 1/2 will be subject to ordinary income taxes and an additional 10% IRS tax penalty. Guarantees mentioned above depend upon the claims paying ability of the issuing company. For more detailed information please ask for a prospectus.
*Guaranteed Death Benefit is based on the ability of an insurance company to pay out the death benefit claim.
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Municipal Bonds & Municipal Bond Funds
U.S. Government Series EE Bonds:
Interest income subject to federal income tax but not to state or local income tax. Pay federal income tax annually as interest accrues, or defer federal income tax until liquidating the bonds.
Interest on bonds purchased in 1990 and later may be tax-free income when used for college tuition and fees.
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Universal/Variable Life Insurance
Universal Life Insurance:
Universal Life combines pure life protection (term) with a cash value fund that accumulates tax-free as long as the policy remains in force.
Unlike deferred annuities or single premium life, universal life is purchased chiefly for insurance. The insurance company deducts certain expenses and the first month's pure insurance protection from the initial premium paid. The balance of the premium earns market rate interest in a cash-value fund which is normally a high-yielding government securities fund. Each month thereafter, the cost of an additional month's pure insurance plus expenses is deducted from the cash value fund.
Advantages:
- Policy earns tax-free interest at current market rates;
- Flexible premium payments. Policyholder can choose to pay for its cots with one single payment, payments for five or ten years, or any other payment schedule desired. Premiums may even be made at different intervals of time or stopped temporarily as long as the next month's policy reserve covers the cost of next month's pure insurance protection;
- Adjustable benefits so a policyholder can increase or decrease the policy face value according to needs;
- Policy loans are generally at a 6% to 8% interest rate;
- Investment, expense and mortality elements are separately defined.
Disadvantages:
- Policyholder ends up with neither the most competitive insurance coverage nor the most competitive savings vehicle:
- Future yield potential is uncertain due to inflation.
Variable Life Insurance:
Variable Life combines the traditional tax-deferred savings functions of life insurance with the growth potential of equities. Like traditional life insurance, variable policies have fixed premiums and a guaranteed minimum death benefit. However, the cash value is not guaranteed and will fluctuate with the performance of the portfolio invested by the insurer.
The policyholder can allocate (and switch) his/her investment choices; for example, growth stocks, aggressive growth stocks, money market funds, real estate securities, etc.
Variable life may be appropriate for policyholders who prefer to combine some insurance coverage with a long-term investment (ten years or more) that can provide additional income for retirement or other needs. Taxpayers should consider variable life only after maximum deductible contributions have been made to retirement plans. Variable products are also attractive to upper income taxpayers in the 31%, 36%, or 39.6% tax brackets who can benefit from tax-deferred compounding.
Advantages:
- Earnings compound tax deferred within the policy;
- Life Insurance death benefits are income tax free to beneficiaries;
- Several investment options with tax-free exchanges are within the product;
- Professional asset management;
- Third-party ownership may result in death proceeds being exempt from estate tax;
- Possible inflation hedge.
*Variable Life Insurance is intended for individuals who have clearly established a need for insurance.
*Variable Life insurance is subject to mortality and expense charges not tpyically found with other types of investments. Withdrawals prior to age 59 1/2 will be subject to ordinary income taxes and an additional 10% IRS penalty. FOr more detailed information, please read the prospectus.
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Tax Managed Mutual Funds
- Check fund's track record. Performed consistently well?
- Compare fund's performance with other funds with similar investment objectives.
- Make sure fund's investment objectives and risk levels is in line with an investor's goals.
- Compare fund's fees and expenses with that of similar funds.
- Is the manager responsible for fund's performance record still around?
- Realize that past performance is a good starting point when picking a fund, but there are no guarantees for the future.
Important: Before investing in a new mutual fund or purchasing additional shares in a fund already owned, investors should call the fund company-to verify the amount of any possible capital gains distribution. The investor can then wait until after the distribution to purchase the shares.
By law, mutual funds must pay substantially all dividends, interest, and not capital gains realized by the fund to their shareholders annually. Capital gains distributions are the net long-term capital gains realized from the sale of securities held by the fund and are included in the price of the funds' shares. Investors who intend to purchase shares of a fund late in a year may do well to wait until after the record date of any expected capital gains distribution in order to avoid an unexpected income tax liability.
Types Of Mutual Funds:
- Aggressive Growth:
Invest in new companies and industries, or those in financial trouble or out-of-favor with the market. Sometimes referred to as Capital Appreciation Funds, they usually have above average increase in price with little or no current income, and very a high risk tax advantage.
- Growth:
Invest in the common stock of well-established companies. The primary goal is to produce an increase in the value of the investment. Investors buying a growth fund are more interested in seeing the fund's share price rise than in receiving income from dividends tax advantages.
- Growth and Income:
Invest in companies that consistently pay good dividends and also have a strong growth potential with moderate risk.
- Index:
Invest in stocks in the companies included in a specific market average or index like Standard & Poor's 500-stock average of large companies; or the Wilshire 4,500 index of smaller companies. Fund mirrors the movements of the market.
- Balanced:
Generally invest in common stocks, preferred stocks, and bonds. Balanced funds provide an opportunity for share price appreciation with added income and price stability from the bonds in the fund. Conservative investors seeking share price appreciation and some dividend income may choose a balanced fund.
- U.S. Government Income:
Invest primarily in a portfolio of income producing securities issued or guaranteed by the U.S. Government, its agencies, or instrumentalities.
The fund's shares, however, are not guaranteed. These funds usually provide dividend income. A conservative investor seeking a monthly income check may choose this type of fund.
- High Grade Corporate Bond:
Invest primarily in high grade corporate bonds. These funds seek to provide a higher level of monthly income than U.S. Government funds and therefore carry slightly more risk. Investors seeking monthly income may choose this type of fund.
- High Yield Bond:
Invest primarily in lower quality corporate bonds ("junk bonds"). These funds provide higher income potential than other bonds, but also entail more risk. Investors seeking maximum monthly income-and willing to tolerate more share price fluctuation-may invest in this type of fund.
- Tax-Free Income: Invest in bonds issued by towns, cities, counties and states to finance public projects. These funds provide income that is free from federal and, in some instances, state or local income taxes. High tax bracket investors wanting monthly income-but not wanting to increase his/her tax burden-may choose a tax-free income fund.
Potential Pitfalls:
1. Tax-exempt interest must be included when computing taxable Social Security benefits.
2. Tax-exempt interest from private activity bonds must be included for alternative minimum tax purposes.
- Global Bond:
Invests primarily in the bonds of governments and companies all over the world, including the United States. These funds seek to provide income and global diversity. An investor wanting international exposure or diversification for an income portfolio would consider this type of fund. Currency fluctuations and political developments add to the price instability of this type of fund.
- International:
Invest in common stocks of companies located outside the United States. These funds provide a way to access opportunities in overseas markets. Investors seeking diversification and share price appreciation, may put a portion of their assets in an international fund. Currency fluctuations and political developments add to the price instability of this type of fund.
- Money Market:
Seek to provide income while maintaining a stable $1 per share price. These funds invest in short-term, high grade securities such as Treasury bills, bank certificates of deposit and commercial paper (short-term IOUs from large, well known, high quality corporations), but are not guaranteed or insured by the U.S. Government. Conservative investors wanting to earn income-while preserving principal-may choose a money market fund.
*Mutual Funds value fluctuate so that an investors shares may be more or less than their orginal cost. For detailed informaiton, please ask for a prospectus.
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Growth Stocks
An investor can enjoy tax-deferred growth in the securities appreciation, and a possible lower capital gains tax upon sale (currently 20% for investments held for more than 12 months). This type of stock does not pay dividends only looks to appreciate.
Three factors make the personal residence American's leading tax shelter:
1. Long term inflation, economic growth, and population growth push real estate values upward.
2. Most of the purchase price can be financed and the interest is tax deductible, effectively cutting the interest cost by the taxpayer's marginal tax rate.
3. Homeowners may exclude up to $500,000 in gain from the sale of a principal residence ($250,000 for single taxpayers). Tax break is retroactive to 5/7/97, and reusable every two years.
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Individual 401k (For Sole Proprietors)
The Tax Relief Act of 2001 enhanced many tax advantaged retirement products to help encourage and strengthen your retirement Savings. Higher contribution limits, increased rollover or consolidation flexibility and catch-up provisions are some of the benefits Congress enacted. This landmark legislation has opened the door to an entirely new retirement option for Sole Proprietors.
The Individual 401k may be right for you if you are:
1. A sole proprietor
2. C or S Corporation
3. Limited Partnership
4. Professional Such as a lawyer, consultant, CPA, medical professional, designer, contractor, real estate broker or freelancer.
Tax Incentives and Benefits of the Individual 401k:
- Tax Deductible profit sharing contributions
- Salary deferral
- Account consolidation: Virtually all existing retirement plans can be converted into this single account.
- Protection from creditors
- Spousal salary Deferral.
- Immediate Vesting
- Flexible Funding: Contributions are discretionary and can change year to year.
- Loan Provision: Up to 50% of plan assets or $50,000 can be borrowed from the plan without taxes or penalties.
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Personal Home
Three factors make the personal residence American's leading tax shelter:
1. Long term inflation, economic growth, and population growth push real estate values upward.
2. Most of the purchase price can be financed and the interest is tax deductible, effectively cutting the interest cost by the taxpayer's marginal tax rate.
3. Homeowners may exclude up to $500,000 in gain from the sale of a principal residence ($250,000 for single taxpayers). Tax break is retroactive to 5/7/97, and reusable every two years.
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IRA / 403b / 401k
- Retirement Plans- 401(K) s, Deferred Compensation, etc:
In addition to IRAs, participate in retirement plans sponsored by employers. The tax -deferred compounding can provide vast savings for retirement.
- Section 403(b) Annuities (TSAs-Tax Sheltered Annuities):
Only taxpayers who work for nonprofit employers are eligible (schools, government, hospitals, etc.). TSAs are like IRAs, except the contribution limits are more liberal.
- Individual Retirement Account (IRA):
There is little reason not to have a "deductible" IRA. An annual $2,000 contribution saves $560 in taxes for taxpayers in the 28% bracket (federal only). The usual objection "What if I need money" suggests poor savings habits.
- Roth IRA:
Contributions to Roth IRA are nondeductible. However, distributions which include earnings are tax free when certain requirements are met.
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Reasons Novice Investors Fail
- Do not understand compounded growth over a period of time.
- Follow investment strategies unsuitable for their situation.
- Do not have financial goals, or they abandon the goals too soon.
- Are greedy and impatient.
- Are influenced by financial publications, which are generally too late or outdated.
- Make investments acting emotionally rather tan rationally. A "hot tip" is usually not. An investor never should be pressured into making a decision.
- Rely heavily on advice from so called "experts".
- Make investments based only on income tax savings.
- Invest with borrowed funds. Pay double-digit interest to gain single-digit growth.
- Become overwhelmed with investment choices and investment advice and end up too uncomfortable to make any decision at all. These investors often have huge amounts of money in their checking and savings accounts.
- Think fixed income is fixed value. Some investors assume a $10,000 bond is worth $10,000 from the time it is issued until it matures. Actually, the value almost always fluctuates, depending on whether interest rates fail or rise.
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Basics of Investing
1. Diversification.
2. Limit risk in portfolio according to stage of life and personal preference.
3. Match investments to current market trends and upcoming profitable market sectors.
4. Coordinate investment plan with taxability now and taxability at retirement.
5. If an investment sounds "too good to be true", it probably is.
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