| |
When it comes to investing, avoiding
taxes should not be your primary concern. Regardless of how much
that financial salesperson talks about the importance of deferring
taxes, you need to stop and consider these important facts before
you make a decision. Otherwise, you can actually lose money instead
of saving it.
As I talk with seniors from across the nation, it’s obvious they
loathe paying taxes. Financial salespeople often play on this
dislike of paying taxes to motivate seniors into buying a
high-commission investment even though it will earn the senior less
in the long run. The only one earning more in this situation is the
salesperson!
There are two basic kinds of tax-advantaged investments—tax-free and
tax-deferred. The two are often confused even though they are very
different. For instance, municipal bonds are tax-free. You don’t
have to pay any Federal income tax on the interest that you earn on
a municipal bond—ever. This allows municipalities to borrow money
for public works projects at lower interest rates, saving the public
money.
The simple way to calculate whether you are better buying a tax-free
municipal bond versus a taxable bond is to divide the tax-free yield
by 1 minus your tax rate. For instance, if you are in the 28% tax
bracket and a 10-year municipal bond is yielding 3.78% then you
divide 3.78 by .72, which equals 5.25%. That means that you would
have to earn over 5.25% on a taxable bond to give you more after tax
income then the municipal bond.
Tax-deferred investments work quite differently. Annuities are the
most often used tax-deferred investment. You don’t avoid paying
income tax in a tax-deferred investment. You only delay paying
taxes, which are due when money is taken out of the tax-deferred
vehicle. If you don’t plan on using the money yourself, the taxes
will still have to be paid at your death.
Not only will you have to pay taxes on tax-deferred investments in
the future, it is likely that you will have to pay more in taxes
then compared to paying the tax now for two reasons.
First, any earnings on a tax-deferred vehicle will be taxed at
ordinary income rates—for instance the 28% we assumed earlier. If
you invested that money in an investment that paid dividends and/or
capital gains and paid the taxes now, you would only have to pay
taxes at the 10% or 15% level.
That’s a huge difference. In our example, earnings taken out of an
annuity will be taxed at 28%. Dividends and capital gains off of a
mutual fund will be taxed at 15%. That’s a 13% difference!
Financial salespeople will use the fear of paying taxes in an
attempt to convince a 70 or 80 year old that they should buy an
annuity. That is completely bogus! Studies have shown that your
money must be left in an annuity for 20-30 years before you begin to
see the benefits of tax-deferral. Again, the only one benefiting
from the transaction is the salesperson. Don’t fall for this trap.
Another trick that financial salespeople will use to sell an annuity
is to say that it will keep your Social Security from being taxed.
That’s true, but if you use an annuity you’ll push all those taxes
down the road. Later on, that could force you (or your heirs if
you’re deceased) into a higher tax bracket and you’d end up paying
more.
Here’s the bottom line. If you’re in a tax bracket of 27% or higher
then use tax-free municipal bonds for the income portion of your
portfolio. For the equity portion of your portfolio, use
tax-efficient vehicles like Exchange-Traded Funds where you can
control the timing of the tax event while having the dividends and
capital gains taxed at much lower rates.
As you can see, there isn’t a single case in my opinion where an
older investor will benefit from a tax-deferred annuity. With
current tax rates it just doesn’t make dollars and sense. Be smart,
do the simple math, and you’ll come out ahead.
Got questions? Go to www.guardingyourwealth.com and click on ‘Ask
Jeff’. I’ll be glad to personally give you an unbiased opinion.
Visit our web site to read previously submitted questions and
answers.
In addition to being a nationally syndicated columnist and Certified
Financial Planning Practitioner, Mr. Voudrie serves clients
nationwide using a proprietary money management system he's
personally developed.
|
|
