Tax Advantaged Investments

1. Tax Advantaged Investments GJ-Chapter 15

2. Tax Sheltered and Deferred Investments One key objective of an investment plan is to maximize the after-tax income of the investor over their lifetime. This may involve tax shelters - either tax avoidance or tax deferrals A tax shelter is any investment vehicle that offers potential reductions of taxable income

3. Tax Shelters and Deferrals Tax avoidance is concerned with legal ways of reducing or eliminating taxes involves such things as: investing in tax favored securities distributing income producing assets to family members not taxed or taxed at lower rates Tax Deferral deals with means of delaying taxes and can be accomplished by shifting income from one year to another or through the use of retirement plans such as IRAs, 401(k)s, Keoghs, and annuities.

4. Tax Favored Income An investment is said to offer Tax-Favored Income if it has any of the following attributes: -offers a return that is not taxable -offers a return that is taxed at a rate less than that on other similar investments -defers the payment of tax to the next year or to retirement -trades current for capital gain income

5. Strategies to Exclude or Defer Tax Liabilities Exclude Income from Taxation: Tax-Free Municipal Bond Interest Treasury and Gov’t. Agency Issues may have tax exemption Sale of Personal Residence 1 time exclusion of $125,000 capital gains tax can be postponed

6. Strategies to Exclude or Defer Tax Liabilities Strategies that Defer Tax Liabilities to the Next Year: Short Sale Against the Box Put Hedge Deep-in-the-Money Call Option

7. Deferral of Tax Liability toRetirement To supplement Social Security, a number of Basic Employer Sponsored retirement programs give employees an option to contribute to retirement programs that provide tax shelter by deferring taxes to retirement. Some of the best known vehicles include: IRAs 401(k)s and 403(b) Keogh Plans Annuities

8. 401(k)s

9. 401(k)s 401(k) plans are actually salary reduction plans offered by employers to employees. [note: 403(b)s are similar plans available to employees of public, nonprofit organizations] A 401(k) plan gives the employee the option to divert a portion of their salary or wages to a company-sponsored, tax-sheltered savings account. Taxes on contributions and investment earnings are deferred until the funds are withdrawn.

10. 401(k)s Participants in 401(k) [403(b)] plans are generally offered several options for investing their contributions, often including: mutual funds (money market, bond, stock) GICs (Guaranteed Investment Contracts) {GICs are portfolios of fixed-income securities with guaranteed competitive rates of return that are backed by and sold by an insurance company}

11. 401(k)s Employee contributions to 401(k) plans are capped with the cap being adjusted annually (indexed to) for inflation. Contributions are “locked-up” and cannot be withdrawn until the age of 59 1/2 (or employee leaves the company) except in a small number of specifically defined “cases of financial hardship.”

12. 401(k)s Example: individual earned $50,000 in 1994 and decides to contribute the then maximum of $9,240 to a 401(k) plan sponsored by their employer. 1994 taxable income will be reduced from $50,000 to $50,000-$9,240 = $40,760. Federal tax at 28% would have been $50,000(.28)= $14,000 are now $40,760(.28) = $11,412. Thus saving $2587.

13. 401(k)s In essence, in the preceding example, the individual will add $9,240 to their retirement account but $2,587 will have been contributed by the Federal Govt. through tax savings. Further, all earnings will accumulate tax-free until withdrawn in retirement.

14. Keogh Plans Allow self-employed individuals to establish tax-deferred retirement plans for themselves and their employees. Payments to Keogh Plans are generally taken as deductions from taxable income. (Thus reduce taxes of self employed individuals) Maximum contributions to Keogh Plans are $30,000 or 20% of earned income, whichever is lower.

15. Keogh Plans Keogh Plans can be established by anyone who is self-employed either full time or part time. They can be opened at banks, insurance companies, brokerage firms, mutual funds, and other financial institutions and contributions must be made before tax returns are filed or April 15th, whichever comes first.

16. Keogh Plans actual investments held in Keogh Plans are self directed by the individual contributor (unlike 401(k)s) income earned accrues tax-free all contributions and earnings must remain in the account until the contributor turns 59 1/2 unless they become disabled or seriously ill. contributions and earnings can remain untouched until the age of 70 1/2 - after which they must gradually liquidated

17. IRAs Individual Retirement Accounts - are self directed, tax-deferred retirement programs available to any gainfully employed individual who can meeting two conditions: -neither you nor your spouse can be covered by a company sponsored pension plan -your adjusted gross income has to be less than $40,000 for a married couple or $25,000 for a single individual

18. IRAs If you meet the two conditions, IRA contributions qualify as tax deductions in the calculation of taxable income, and all earnings in the IRA account accrue on a tax deferred basis. Individuals not meeting the two conditions, can still contribute to an IRA account up to a maximum of $2,000 a year. Contributions are on an after-tax basis, though all earning are tax deferred. IRAs are self directed and funds can be invested in a wide variety of investment vehicles.

19. IRAs Withdrawals from an IRA prior to the age of 59 1/2 are subject to a 10% penalty on top of the regular tax on the withdrawal itself.

20. Funding Keoghs and IRAs The nature of these retirement programs generally favors a more conservative investment approach which emphasizes income-producing assets (as opposed to capital gains producing assets) two basic reasons: -growth oriented securities are by nature more risky -losses cannot be written off from the sale of securities held in these accounts

21. Funding Keoghs and IRAs It is certainly reasonable to have some of your investments in these plans in growth oriented investments Some types of investments are inappropriate for these accounts, such as: tax-free munis since they are all ready free of tax on interest earnings

22. Tax Deferred Annuities A tax deferred annuity may be worth more to an individual investor than any other single tax strategy Annuity - a series of payments guaranteed for a number of years or over a lifetime.

23. Types of Annuities Single premium annuity - contract purchased with a single, lump- sum payment - purchaser receives a series of payments that begin immediately or at some point in the future Installment annuity - contract is acquired by making payments over time; at specified future date, the installment payments and interest earned are used to purchase an annuity contract. Immediate annuity - contract under which payments to the annuitant begin as soon as it is purchased. The amount of payment is determined statistically and is a function of the length of time the annuitant is expected to live.

24. Types of Annuities Deferred annuity - contract in which the payments to the annuitant begin at some date in the future. The date is specified in the contract or at the annuitant’s option. The amount to be received depends on the annuitant’s contributions, the interest earned, gender, age, date the payments are to begin. Fixed annuity - an annuity contract that pays an unchanging amount of monthly income during the distribution period. Variable annuity - an annuity contract that adjusts the monthly income it pays during the distribution period according to the investment experience of the insurer.

25. Investment Suitability Principal positive feature is the ability to accumulate tax-deferred earnings Also relatively low risk of annuities Negative features include: lack of inflation protection high sales charges and administration fees

26. Buying Annuities Annuities are sold by licensed salespeople and many stockbrokers Remember that the annuity is only as good as the insurance comp. that stands behind it. Always check rating such as Best’s Insurance Reports to determine the quality (financial strength) of the insurance company - rating range from a high of A+ to a low of C.

27. Characteristics of Deferred Annuities Current interest rate (on an annuity) -is the yearly return the insurer is now paying on accumulated deposits. This CIR fluctuates with market rates over time and is not guaranteed. Minimum Guaranteed Interest Rate - this is the minimum interest rate guaranteed by the insurer over the full accumulation period. (in examining promotional materials remember the MGIR is all you are guaranteed while the company may publicize (emphasize) the CIR

28. Special Tax Feature both single premium and installment, tax-deferred annuities have an advantageous tax shelter feature: -interest earned on the purchaser’s contributions is not taxed until it is actually paid by the insurer

29. Investment Payout the investment payout provided by an annuity is realized when the distribution period begins the amount received depends on - the amount accumulated in the account - the payout plan chosen the key return for the annuitant is the actual return on investment after all sales charges and administration fees are deducted.