PSST. Want to earn the equivalent of 17.86 percent on your money? No, you don’t have to finance a clandestine flight to Colombia or even a wildcat drilling venture in Pitchfork, Wyoming. There are rewarding investment opportunities as near as your local broker, bank or savings and loan that will keep you a step ahead of the tax collector but won’t land you in jail or in tax court.
It’s too late to do much about 1982 taxes (with one exception, which we’ll discuss later), but now is the perfect time to start whittling on 1983.
For those who will be in the 44 percent tax bracket in 1983 (with a joint taxable income between $60,000 and $85,600), a 10 percent tax-free yield is the equivalent of a 17.86 percent taxable return. Some tax-privileged investments have been returning even more than 10 percent. But you don’t hear much about them, with all the hype about the money-market and su-perNOW accounts offered by banks and S&Ls. Certainly these accounts are worthwhile, but they won’t cure all your financial woes. For a couple making $60,000 a year, $440 of every $1,000 earned in taxable interest goes to the IRS, and even if inflation holds at about 5 1/2 percent a year, that still puts the bite at close to $500 before a dime is spent.
Here’s a rundown on the tax-exempt and tax-deferred investments that even the IRS recognizes as proper and legitimate methods of protecting income and sheltering growth accounts. Each has pros and cons, and some suit certain investors better than others, but there’s bound to be something here that you can use effectively to get the government out of your pocket.
Municipal bonds. “Municipals are a bargain right now,” says Linda Kelly, a bond specialist with Rauscher Pierce Refs-nes Inc. in Dallas. “There have been opportunities lately to buy tax-exempt, AAA-rated municipal bonds that pay higher interest than some of the taxable treasury notes coming on the market.” Ratings are assigned by Standard and Poor’s and by Moody’s, which are independent rating services; the higher the rating, the less the risk to investors.
There are two major types of tax-exempt bond instruments: general obligation (GO) bonds and revenue bonds. GO bonds are general obligations of a municipality supported by the city’s taxing power. Revenue bonds are secured by the future income of the revenue-generating facility constructed with the proceeds from the bonds. For years, GO bonds were investors’ favorites, but in view of taxpayer resistance evidenced by such phenomena as the passage of California’s Proposition 13, favor seems to be shifting to the revenues. Kelly says she would just as soon own a good utility revenue bond as a GO bond issued by a major city, even though the GO bond might be rated higher.
“If you had a tax bill in one hand and a utility bill in the other, which would you pay first?” she asks.
Don Avant, account executive in the Dallas office of E.F. Hutton and Company, likes a new type of instrument called the “zero coupon bond.” “It’s ideal for the investor who has a predictable need at some time in the future,” he says. The zero bond doesn’t pay periodic interest but instead sells at a substantial cash discount off the face value. For instance, you can buy a bond with a $100,000 face value that matures in 20 years for about $12,000, the actual cost depending on the going rate the day you buy it. After the 20 years expires, you can cash the bond in for $100,000 tax free.
“It’s a very suitable vehicle for the 40-year-old company executive who knows he’ll be facing mandatory retirement at 62,” says Avant, “or for the young couple who wants to be ready when the kids are old enough for college. The beauty of it is that the interest doesn’t get away from you in little dribbles.”
Avant says that there is not much risk of an investment-grade bond defaulting, though it can happen. “During the Depression, less than one-fourth of 1 percent of the investment-grade bonds went into total default,” he says. There is a real risk, however, in suffering a capital loss if interest rates go up after you buy your bond, //you have to sell it before maturity. If you can hold on until its maturity, you’re still entitled to receive the face value from the issuer. Though it depends on an investor’s particular situation, it’s often better to buy intermediate-term bonds -say, those with 10- to 15-year maturities -so that if rates rise you won’t be saddled with a loser for a lifetime. If rates continue to fall, you can earn a nice capital gain on a bond purchased earlier, in addition to the tax-free income in the interim.
Municipal investment trusts. “This has been one of our most popular products,” says Dick Humphrey of Rauscher Pierce Refsnes, and no wonder. Alert investors locked in tax-free income of 13 percent during early 1982 by taking advantage of an investment vehicle that has even less risk than the individual bonds. In a municipal investment trust, a number of bonds – say, 25 or 30 – are lumped together in a single package, thus spreading the risk in case one of the bonds should happen to belly up somewhere down the line. A single trust package might include bonds issued by the New Jersey Turnpike Authority and the city of McAllen, Texas. The trusts have the same interest rate exposure as individual bonds, but recently you could still get into a trust paying about 10 1/2 percent, nearly twice the rate of municipal bonds 10 years ago.
Five thousand dollars is generally the minimum purchase for individual bonds, but units in the trusts can be purchased for as little as $1,000. A brokerage commission of about 4 percent is included in the purchase price, which means that the trusts are not suitable vehicles for the short term. If you decide to sell back your $1,000 bond the day after you buy it, you’ll get only $960, and sometimes less than that. Some brokers imply in their prospectus that they intend to buy back at price, which is higher than the “bid,” but they don’t. If you receive only the bid price, your proceeds drop even further to about $945. This is not a major problem if you amortise the gig over a number of years, but over the short term you’d be better off with a regular money-market account.
Municipal bond funds. The municipal investment trusts are “closed-end,” meaning that the same bonds in the package at the time of issuance remain there for the life of the deal. Municipal bond funds are “open-end” vehicles managed by investment houses such as the Dreyfus Corporation, which add to and subtract from the inventory as they perceive an opportunity to improve the yield or the security. A management fee of up to 1 percent a year is charged for service, but there is no brokerage commission.
The success of the managed funds depends on the expertise of the managers. Because of the minimal costs involved, the funds are more suitable than trusts for investors who might need to pull out in a year or two. Read the prospectus carefully, though, to see what you’re getting. Most trusts are comprised of A-rated bonds or better (investment grade), but this is not always the case with the funds. In order to boost interest results, some funds have large chunks of bonds that aren’t rated at all.
Don’t confuse tax-exempt bond funds with tax-free money-market funds; some investment houses offer both. The bond funds are comprised of the municipal bonds we’ve been talking about, but the tax-free money-market funds invest in short-term securities of states and public agencies that pay much lower interest rates. When bond funds recently paid more than 9 percent, the tax-free money-market funds were yielding more than 5 percent.
Tax-deferred annuities. All the investments we’ve mentioned so far involve income that is free from tax, now and forever. But let’s shift gears and look at another extremely rewarding endeavor: tax deferral. Used wisely, it can earn you as much or more than tax-free securities because you can use the money you would have paid to the government to make more money through the use of a much wider range of available investments.
The tax-deferred annuity was originally intended as a long-term investment vehicle, but insurance companies and mutual-fund groups combined their creative talents a couple of years ago to create an investment tool that could also be used by short-term investors. The gimmick, called the “switch-fund annuity,” stuck in the craw of the IRS, which retaliated last August.
“The tax-deferred annuity has taken a 180-degree turn,” says Jack Carley, a tax partner in the Dallas office of Price Wat-erhouse. Before the new rule, an investor could withdraw the full amount of his original investment without tax consequence. Now, the IRS deems any withdrawal from an annuity to be “interest first.” Not only that, but if you withdraw from your account during the first 10 years, you’re subject to a 5 percent penalty unless you’ve reached age 59.
So forget tax-deferred annuities as a short-term investment, but they’re as good as they ever were as a long-range shelter. Two basic types of annuities are on the market: the single-premium fixed annuity and the variable annuity. The fixed annuity is a contract between you and the insurance company that calls for you to earn a stated amount of interest over a long term. Even after the substantial decline in interest rates during the last part of 1982, you could still buy tax-deferred annuities paying 12 to 13 percent. But read the fine print in the contract; the issuer may be able to retreat to a lower interest payout if rates keep tailing.
The variable annuity allows periodic payments to the issuer over the life of the annuity contract. This is the type that was used to permit investments in mutual-fund families. Dick Humphrey says that the IRS has done more than just tighten up the rules on withdrawals from these accounts. The IRS says now that it’s not cricket to team the insurance contracts with mutual-fund families that are readily available to investors on the open market. Now the insurance company/mutual-fund combines are restructuring their programs to offer basically the same type of investment vehicles that were available before but without the name identification, which means you won’t be able to track their performance in the morning papers.
IRA and Keogh accounts. “Eighty percent of our clients had IRAs in 1982,” says Dallas financial planner Bill E. Carter, “and this year we’re expecting 90 percent.” Most of Carter’s clients are in upper-income brackets, but he believes that everyone should have an IRA. “It gives everybody a chance to take advantage of tax-free growth without the exposure to high-risk ventures that some people can’t afford,” he says.
IRA and Keogh accounts offer the same advantages as the tax-deferred annuities, but with one distinct and extremely important difference: IRAs and Keoghs both allow you to exclude the amount of your annual contribution from your taxable income for the year during which you contributed.
Keoghs are available only to the self-employed (including salaried employees who moonlight on their own), but now IRAs are available to anyone with earned income. Keoghs permit the investment of 15 percent of self-employed income, up to $15,000; IRAs allow an annual tax-deferred investment up to $4,000 per working couple, $2,250 per couple where only one is employed and $2,000 for single persons. The IRA is the procrastinator’s dream -if you make a contribution between now and April 15, 1983, you can deduct the amount contributed from your 1982 taxable income. You can’t do this with a Keogh, though, unless you had established the account before December 31, 1982.
Carter recommends a “self-directed” IRA that allows an investor to remain light on his feet and switch from one vehicle to another when the situation calls for it. Banks and trust companies will handle self-directed accounts, but be sure to compare their fees before committing and find out what kind of progress reports they’ll furnish you.
Don Avant says an IRA or any othertype of tax-exempt or tax-deferred investment should be geared to what he calls aninvestor’s “risk tolerance level.” “Youshould get into something you can makemoney on but still sleep at night,” hesays.
