MANAGING YOUR MONEY : THE RIGHT PATH : It’s Back to the Basics on Tax Shelters : The exotic investments still exist. But you’re probably better off with the more mundane, including tax-free bonds and home mortgages.
Thanks to the new tax act, many taxpayers will find themselves moving into higher tax brackets next year. And more taxes mean more curiosity about tax shelters and a revival in such tried-and-true investments as municipal bonds, tax-free money market funds, real estate--plus more exotic investments.
The latest tax bill keeps intact the 1986 reforms that removed most of the old tax shelters designed more to save taxes rather than to make much money. Since then, the rule has been: “Steer clear of any tax shelter that does not make economic sense on its own,” says Joseph Knott, tax partner with Kenneth Leventhal in Century City
But whatever the tax shelter, remember that most of them require patience to pay off, and that the payoff is largest for those facing the biggest tax bite. Furthermore, tax savings should be only one method of gauging an investment’s value.
Still, even for middle-income earners, some tax shelters make sense.
One that is generating tremendous interest is the new tax-free California tuition bond, actually a zero-coupon bond, that pays all the interest when the bond matures in eight to 18 years. At the first sale last month, an 18-year bond offered an annual yield of 7.35%.
“Those California bonds are a better deal than just about anything else around,” says Julian Block, a writer of tax guides in Larchmont, N.Y.
Another relatively simple tax shelter is a money-market fund that pays interest free of state and federal taxes. Morrie W. Reiff, a financial adviser in Encino, steers his clients into the Franklin California Tax-Exempt Money Market fund, which invests in short-term municipal notes.
For a $500 initial deposit, the fund offers check writing and a recent yield of 5.4%. For someone in the 28% federal tax bracket, that’s equal to an ordinary taxable yield of 7.5%. More than a dozen other companies offer similar money market funds, including Dean Witter, Fidelity, Kidder, Peabody & Co. and T. Rowe Price.
And there are always municipal bond funds that pay interest exempt from state and federal taxes. However, before investing, check the performance history of the fund; be aware that some bond funds charge 4% or 5% fees up front, while others are no-load funds with modest annual management fees.
Although the interest--recent yields have hovered around 6.5%--is tax free, fund managers are constantly buying and selling bonds, and your principal can fluctuate widely in value, just as in a regular stock mutual fund. Furthermore, remember that if interest rates soar, the current value of bonds sink and vice versa.
One caveat: Over the past 60 years, the stock market has outperformed the bond market. It’s your call whether this will keep up. But with a recession looming, many think that bonds will out-leg stocks over the next few years.
Julian Block says to keep in mind such obvious tax shelters as your home and IRAs.
Individual retirement accounts still offer immediate tax deductions for middle- and lower-income earners who are not covered by employer pension plans. The IRAs shelter contributions of up to $2,000 per year--plus any interest generated by the contributions--until the funds are withdrawn by a taxpayer who’s at least age 59 1/2. Similarly, the self-employed can invest up to $30,000 a year, or 15% of income, in a Keogh retirement plan.
Many employers offer another effective tax shelter, 401(k) retirement plans. These plans allow employees to contribute a portion of their pretax salary to a fund that generates tax-deferred interest. A special bonus of many plans is matching tax-deferred contributions by employers.
Despite rumblings by the budget cutters, Congress left intact home mortgage deductions. Home owners may still deduct all the interest on the mortgages of first and second homes, up to a maximum of $1 million. Furthermore, if you sell your home for a profit, you can defer taxes on the profit by purchasing a replacement residence worth the same or more than the original; the window of opportunity for your new purchase is 24 months prior to or after your home sells. Finally, once homeowners turn age 55, they can take advantage of a one-time exclusion of up to $125,000 of the profit from selling their principal residence.
Although the real estate market remains stagnant throughout much of the nation, many financial advisers still endorse buying rental real estate as a tax shelter.
If owners meet the Internal Revenue Service’s definition of “active participation” in the management of the property, they may deduct up to $25,000 a year in rental losses against their adjusted gross income up to $100,000. The deduction begins to phase out for annual incomes above $100,000 and is eliminated entirely for taxpayers with adjusted gross incomes of more than $150,000. Another advantage to rental property ownership is depreciation; the IRS lets you write off about 4% of your building’s value each year for wear and tear.
John Tangney, tax partner with Price Waterhouse in Woodland Hills, gives this hypothetical example of what rental property ownership can mean to a taxpayer.
You buy a fourplex apartment building for $300,000; $240,000 of it is for the building so the owner gets about an $8,700 tax deduction each year for depreciation.
Tangney figures that the owner might get close to breaking even on the cash flow. But the losses, plus depreciation, work out to about a $13,000 tax deduction, which for someone with $100,000 in adjusted gross income means a savings of about $4,000 a year in federal taxes.
Exotic tax shelters still exist: in oil, gas, computer leasing, even shipping containers. But financial advisers agree that you are generally better off being cautious about tax shelters.
TAX-FREE INVESTMENTS
The interest yield on a tax-free investment is usually lower than a taxable one. But to find out which investment actually earns more, you must compare your effective tax-free yield with a taxable return.
Use this formula: Say you are in the 28% federal tax bracket and have a 7% tax-free yield on your investment. Subtract your tax bracket from 100 (100 minus 28 equals 72). Then divide your 7% yield by 72. In this case your tax-free yield is equivalent to an ordinary taxable yield of 9.7%.
Below are estimates of federal tax brackets for 1991 which compare tax-free and taxable investment yields (the figures don’t take into account the new limits on deductions at higher income levels).
15% 28% 31% Single returns 0-$20,300 $20,301-$49,200 $49,201-plus Joint returns 0-$34,000 $34,001-$82,100 $82,101-plus
Tax-free yield Equivalent taxable yield 4% 4.7% 5.6% 5.8% 5% 5.9% 6.9% 7.2% 6% 7.1% 8.3% 8.7% 7% 8.2% 9.7% 10.1% 8% 9.4% 11.1% 11.6% 9% 10.6% 12.5% 13.0%
Source: Estimates from the House Ways and Means Committee, and the National Taxpayers Union
