-- Posted Thursday, 5 December 2013 | | Disqus
By Dennis Miller
Since the latter part of 2008, the yield on cash has been so low that sheltering it from taxes didn't seem to matter. But if—as we expect—high rates of price inflation are waiting in the not-too-distant future, then sheltering interest income will be very important.
There may be lag time, but interest rates generally track the rate of inflation. So if inflation returns to a 1970s-like 14%, a one-year CD might yield near 15%. Don't get too excited. The real, after-inflation return would still be in the 1% neighborhood, but you would be taxed on the full 15%. So much for your windfall! No one wants to pay taxes on a real yield of 14%, let alone 14% in phantom income. In this high-inflation world, enjoying the safety and readiness of a cash reserve would be painfully expensive. Unless, of course, you could shelter your interest income from taxes.
Interest rates and inflation won't also move in lock step. It's quite possible that interest rates could be 18% while the inflation rate is only 14%. Furthermore, capital markets react to inflation before it filters into consumer prices. There's a small lag between the two, as bond prices include expectations of inflation rather than historical inflation. Nonetheless, if the spread between inflation and interest rates gets very narrow, investors should take a few steps to optimize their yield holdings.
Retirement Plans
The simplest, most cost-efficient way to shelter interest income is through an IRA, 401(k), or other tax-favored retirement plan. There is no hurry, but when inflation and interest rates start moving up, it's time to funnel spare cash in to your retirement portfolio.
Of course, even if you are very wealthy, there are limits on how much you can contribute to an IRA, 401(k), or one of their cousins. In the case of a traditional IRA, if it isn't as big as you would like (compared to the total value of all your investments), there is a way to increase its size by it effectively absorbing assets you already own. You can learn how to do just that in our Yield Book special report.
If IRAs or other retirement plans don't have enough room for nearly all your cash and near-cash assets, the alternative – a second choice, but in some cases a good choice – is to use a deferred annuity. Besides protecting money from inflation, deferred annuities can be used to invest in foreign currencies and diversify away from a rapidly depreciating dollar.
Deferred Annuities
In a deferred annuity, your income is shielded from taxes until maturity, much like it is in a 401(k). The annuity's returns are only taxed upon withdrawal.
Though an annuity presents some tax advantages, it's something to buy only after you've weighed all the features. First of all, the annuity is a deal between you and an insurance company. It is not traded on the open market. In the securities market, you almost always get a fair price for any investment instrument, as market watchers will bid up the price of any underpriced asset and will short an overvalued asset. However, with an annuity, it's impossible to tell how the market might value the deal. The burden is on you to figure out the value. You need to shop.
Second, annuities are difficult to compare. In the bond market, comparing one bond to another isn't particularly hard. On the other hand, almost every annuity comes has different details on early withdrawal penalties, fees, and interest earnings. On top of that, many annuities have a link to life insurance, making it even harder to assess the deal.
And third, you need to consider the insurance company's creditworthiness if you're choosing a fixed annuity. Annuities aren't FDIC insured. An insurance company earns the money to pay interest on your fixed annuity by making investments of its own – perhaps shrewdly and cautiously, but perhaps not. If its investments don't work out, it won't be able to pay you what it promised.
Before buying a fixed annuity, check the insurance company's credit rating from Moody's, S&P, and Fitch. Those ratings aren't infallible, but they help. This is particularly important for fixed annuities. Variable annuities, on the other hand, do not rely on the insurance company's creditworthiness.
Variable Annuities
The variable annuity is worth mentioning because it is so aggressively sold. Though there are many types of variable annuities, most share a few common characteristics.
Each is purchased with a single lump sum or periodic payments. Each allows contributions to compound tax-free during the accumulation period and also allows the purchaser to determine the date in which the accumulation period ends and the withdrawal period begins.
When the withdrawal period does begin, so does taxation. And prepare to get dinged, because any gain on the amount contributed to a variable annuity (or any other) is taxed as ordinary income.
Expect to also get dinged again on the fees, because variable-annuity fees are generally high compared to other investments. Typical fees include the mortality and expense (M&E) charge, the management fee, and the surrender charge.
The M&E charge covers various selling and administrative expenses. It also compensates the insurance company for taking on some of the risks associated with the contract. For example, if the contract provides guaranteed lifetime payouts, then the insurance company will price the risk of you living too long into the M&E charge: in this case, you might think of it as the "immortality charge." The M&E fee varies, but the industry average is roughly 1.25%.
The management fee sounds made up, but it isn't. This fee goes toward the costs associated with managing the investments within the sub-accounts. And sometimes it's replaced with several smaller fees with kooky names. Regardless of how it's presented, you can expect to pay around 0.85%; but as always, shop around for the best deal.
The surrender charge – a fee for early liquidation – is the one fee that can and should be avoided just in case of emergency or if a better investment opportunity should present itself. However, any withdrawal before the age of 59.5 will come with an unavoidable 10% tax penalty.
Despite the fee frenzy, the variable annuity is a very popular product, mostly because it does offer some long-term protection from the printing press.
The return on a variable annuity is based on the performance of an underlying basket of securities similar to that of a mutual fund. The purchaser selects the "fund" (called a sub-account) and assumes all the risk associated with the investment. This may not seem like too great a deal compared to a fixed annuity, but higher return comes with greater risk.
Investors seeking to mitigate this downside risk should consider a variable annuity with a living-benefit rider. There are many different types of living-benefit riders to choose from, but they all guarantee some sort of minimum payout. For example, the lifetime withdrawal benefit rider guarantees a certain percent of the original investment will be paid out regularly until the day the grim reaper comes. So even if your account goes to zero, you will still receive a regular income stream for life. But, of course, this guarantee isn't free.
If you decide the annuity route is the best for you, there's a lengthy list of factors to consider—too lengthy for one article. That's why we created Annuities De-Mystified, which will arm you with a variety of strategies to help you determine whether an annuity is suitable for you and how to find one that offers the income stream you want at the best possible price. In it you’ll find our 8-point checklist to unravel whether an annuity is truly a good fit for you and our 9-point plan showing you what to look if it is. The report also includes an important overview of the risks associated with annuities – risks that agents won't often voluntarily tell you about. Here's the link for a copy of the report.
-- Posted Thursday, 5 December 2013 | Digg This Article
| Source: GoldSeek.com
