|
Investing tax-free income
|
 |
February 10, 2000: 1:23 p.m. ET
Expert advises tax-efficient funds instead of annuity as a good option
|
NEW YORK (CNNfn) - If you get a disability check from the government, you might not know where to invest the money. Annuity or mutual fund?
In response to a reader's question, Elissa Buie, a certified financial planner from Falls Church, Va., and a member of the Financial Planning Association, suggested index mutual funds, tax-managed funds, or funds with a low turnover rate.
Ask the expert a question.
I have just left military service after 14 years. As you probably know, the good old W2 form issued annually from Uncle Sam always has the box checked stating you are a member of a qualified pension plan. Unfortunately, it doesn't say that you are not "vested" until you reach 20 years of service! Nevertheless, I found out that the VA considers me "disabled" and will pay me about $800 a month -- tax free. My quandary-- where to put the money? Stock investing obviously puts me at risk to pay tax on dividends and capital gains. Stashing it in an annuity (I have had Fidelity's Contrafund annuity for five years) would get around the annual tax issues, but set me up down the road to pay it. Also, traditionally, annuities have not been the same rate of average return as securities. Any advice?
Well, $800 tax free is a nice amount of money to accumulate monthly. This amount saved over a 10 year period and invested in a stock portfolio earning 10 percent will accumulate to over $160,000 -- before taxes. After taxes, it will be quite a bit less. Hence your question.
First, a caveat. While planning for the tax ramifications of any investment
decision is certainly important, it should not be the proverbial "tail wagging the dog." It is the ultimate after-tax return that matters most, not the nominal amount of taxes paid.
Second, a broad consideration. Your overall investment portfolio should be well diversified. So if you have other investments that are invested in an emergency fund and in other asset classes, you may be considering putting all of this money in stocks in order to maximize your potential for the long run. That is the assumption upon which these recommendations are based.
You raise the idea of investing in an annuity. The problem with an annuity is that there are additional expenses charged on the annuity in addition to the regular investment expenses. These serve to reduce your return. Secondly, and very importantly, all of the income is ultimately taxed at ordinary income rates, eliminating your ability to convert any of the income to lower capital gains rates.
Here is what I would suggest. With $800 per month, you are not going to be able to build an individual stock portfolio for some time. With mutual funds, you do lose some control over the taxability of earnings as the manager will decide what and when to sell, and when he/she does so, you will pay your share of taxes on the earnings. However, there are mutual funds with very low turnover rates -- meaning they sell very infrequently. These funds tend to generate less realized taxable income on an ongoing basis, meaning that you pay taxes on the built up gain when you sell. And those taxes are paid at capital gains rates. Some mutual funds are specifically offered on a tax-managed basis, meaning the manager considers how to offset gains and how to minimize taxes as part of his/her management philosophy.
And then there are index funds. Index funds do not actively trade the underlying stocks at all. They only buy and sell in response to inflows and
outflows of money and to changes in the index holdings itself. This lower turnover results in lower realized taxable income.
There are two important issues to watch when you are considering these types of (or any) mutual funds. First, look at how much they pay in dividends.
Dividends are taxed at ordinary income rates and you may want to consider
mutual funds that invest in smaller companies that don't pay dividends (as
long as this meets with your risk tolerance). Second, many of these mutual
funds that are considered tax-beneficial have significant built in gains.
This is because they've been doing such a good job deferring realized gains.
But what it means is that when you buy into the mutual fund, you may have to pay taxes on these accumulated gains if the manager decides to sell those stocks responsible for those gains.
Using these types of mutual funds (low turnover, tax managed or index) will
reduce, but not eliminate, your taxable income on an annual basis. But the
taxable income that is deferred but eventually realized (either because you
sell or because the manager sells a stock with accumulated gains) will be
taxed at capital gains rates. This can result in a significant tax saving even if it's not tax elimination!.
After you have accumulated a significant sum, you can consider buying
individual stocks. This would enable you to have complete control over the
taxable gains being generated. Of course, you still want to be able to sell
a stock that has met your targets, so this is really only a temporary fix.
You might consider putting $2,000 (plus $2,000 for your spouse if you are
married) into a Roth IRA if you have earned income. The earnings on a Roth
IRA are never taxed. While this won't use your entire $9,600 per year, it is an excellent idea for $2,000/$4,000 and the money can be invested in any type of investment security (e.g. mutual funds, stocks, etc.). You should also maximize your contributions to any employer-sponsored retirement plan to which you have access, even if it means using some of this $800/month to
replace earned income that you have decided to defer into a retirement plan.
In summary,
1. Use mutual funds that are designed to or that have historically been
managed without generating significant taxable gains.
2. Maximize your contribution to a Roth IRA (and to other retirement
plans, if applicable).
3. Manage the portfolio for return, first and foremost, setting tax
reduction as a secondary objective. 
-- compiled by Lucy Banduci
|
|
|
|
|
 |
|
