Tax planning: Every time is the right time
Many people think that the only time they need to worry about tax planning is at or near retirement. But in fact, every time is the right time for tax planning:• When you’re 25-40, your income is typically rising and so is your tax bracket.• When you’re 40-55, you’re probably at your highest earnings level, and at your highest tax bracket, even though college tuition bills may be coming due.• When you’re 55-65, you need to make sure you’ll have enough to maintain your standard of living after you retire.• After 65, you may be on a fixed income, but inflation will continue to erode the value of your savings.So tax planning isn’t something for other people to worry about, it’s something we all need to do regularly. What counts isn’t what you earn, it’s what you keep after taxes. So how can you help reduce your taxes ,now and in the years to come?AnnuitiesSimply stated, an annuity is a contract between you and an insurance company. You pay a premium. In turn, the insurance company pays interest on that premium for a specified period. Under current tax law, during that time, called the accumulation phase, your contract’s value grows tax-deferred, meaning it won’t be taxed until you take it out. Your money is growing in three ways: the premium is earning interest, the money you would normally pay in taxes is earning interest, and the interest is earning interest.After the accumulation phase (usually at retirement), a payout (usually monthly) is determined, based on the value of the contract, the current interest-rate market, and your life expectancy according to the mortality tables. The money you receive will then be taxed at your current tax rate, which should be lower than in your earning years.Those who have already retired can benefit from annuities as well. For instance, if you’re 65 or older and do not have an immediate need for all the income generated by your investments, shifting some assets into an annuity contract may help reduce your tax liability.Municipal BondsHistorically, safety of principal has been one of the greatest benefits of municipal bonds. That safety, coupled with tax-exempt yields, makes municipal bonds an attractive source of fixed income.Municipal bonds are issued by state and local governments to raise money for public purposes such as construction projects, maintaining streets and highways, water and sewer systems, housing, and hospitals. Under current law, the interest income you earn on these bonds is exempt from federal taxes (unless you’re subject to the alternative minimum tax, or AMT). If you buy a municipal bond issued by the state in which you live, the interest is also often exempt from state and local taxes.With a zero-coupon municipal bond, you invest a fraction of the face amount of the bond and allow the interest to compound until maturity. This is a choice for young families just starting out who may have concerns about future college tuition. The money is accumulating rather than being paid to you as income. Over the years, this money will grow until the bond matures and college tuition is due.Tax-Exempt Mutual Funds and Unit Investment TrustsIf you’re interested in the tax and safety benefits of municipals but would like to diversify your investment in a bond portfolio, you may want to consider a tax-exempt mutual fund (municipal-bond fund) or unit investment trust.Both funds and trusts are made up of bonds chosen by professional portfolio managers. They offer professional expertise and diversification, which can reduce your investment risk. And you still enjoy the same tax-exempt income, especially on a portfolio of bonds issued by the state in which you live. If you are in a high tax bracket, or for any number of other reasons need to reduce your taxable income, municipal bond funds provide interest that is free from federal (and, in some cases, state and local) taxes. However, some securities in the fund may be subject to Alternate Minimum Tax and distributions of capital gains from municipal bonds funds are generally taxable.A municipal-bond fund is open-ended and may expand. The manager may buy and sell bonds to adapt to changing market conditions, so the return on your investment fluctuates. Once a unit-trust portfolio is initially selected, it remains constant, so the rate of return on your investment is fixed.Take, for example, a young couple with a limited amount of money to invest. A unit trust offers the opportunity to make the most of a relatively small investment, while enjoying many of the advantages of larger investments.Shares of unit trusts can be obtained for as little as $1,000. If purchased in your state of residence, they can be double- or triple-tax-exempt. Interest can be collected monthly, quarterly, or semi-annually.Fraser Horn and Dudley Irwin are investment advisers in Edwards where they run 1st & Main Investment Advisors. Call 926-2500.
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