TIPS on
Inflation-Proofing Your Portfolio |
The Federal Reserve continues to leave interest rates at
historic lows even though it indicated
its concern about inflation. What will happen in the future is
obviously uncertain, but no matter how high inflation may go, there are
a couple of government investment vehicles that provide protection:
- U.S.
Treasury Inflation Protected Securities, or TIPS,
have been around since 1997.
They
are
marketable securities with principal and interest payments that are
adjusted for inflation.
- Series
I U.S. Savings Bonds (I Bonds) are an
inflation-adjusted version of the more-familiar Series EE
Savings Bonds.
- Equity-Indexed Annuities protect
the principal of your investment with giving upside potential if the
stock market index rises.
Life
Insurance with Annuity - Tax Free Option
Life
insurance is given
special tax treatment under the Internal Revenue Code. Essentially, no
tsax is paid on the built-in gain on the policy so lonmg as the policy
stays in force until death. By purchasing life insurance with a large
investment componet, the gain is tax free.If it is put into an
Irrevocable Life Insurance Trust, it can be given to your heirs without
Estate of Goift Tax.
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TIPS
Basics
TIPS Notes
and Bonds are issued in terms of 5, 10, and 20 years. Cash interest
payments are made twice a year.
Recent issues have paid interest rates ranging from a high of 4.25
percent to a low of 1.625 percent. Of course, these interest rates
sound pretty low, but please keep reading to find out about the
inflation-adjustment feature.
TIPS
investors receive an inflation-protected rate of return in the form of:
- The
semiannual cash interest payments (at the fixed stated interest rate),
based on inflation-adjusted principal balances, plus
- A larger
inflation-adjusted principal payment at maturity or upon sale in the
secondary market.
At maturity,
if inflation has risen and increased the value of the underlying
security during its term, the U.S. Treasury pays you the
higher inflation-adjusted principal. On the other hand, if deflation
occurred over the life of the security and decreased the security's
value, Treasury pays you the original face value of the
security.
In contrast,
people who invest in garden-variety Treasury Notes won't receive
anything to compensate them for higher-than-anticipated inflation.
Key
Point: Like other debt
instruments with relatively long periods to maturity, the market prices
of TIPS Notes and Bonds fluctuate daily due to interest rate changes
and other economic factors. However, interest rate changes that are due
solely to expectations about future inflation rates should not
drastically affect the market prices of TIPS instruments. (Daily prices
and yields on all U.S. Treasury debt securities, including TIPS, can be
found in The Wall Street
Journal and other sources.)
Tax
Planning
Implications:
With
TIPS, the only bad news can be the tax rules. When you hold
TIPS in a taxable account,
you must pay current federal income taxes on both the cash interest
payments and
the inflation adjustments to the principal of the TIPS Note or Bond. Of
course, taxes are due at your regular federal income tax rate, which
can be as high as 35 percent.
Paying high ordinary rates is not good, because you won't actually
collect any TIPS principal adjustments until the issue matures or is
sold in the secondary market. Nevertheless, the U.S. Treasury wants its
share now.
Fortunately,
there's an easy solution to this tax dilemma. Only buy TIPS for
tax-advantaged retirement accounts such as traditional or Roth IRAs,
401(k) plans, Keoghs and SEPs. That way, the unfriendly tax treatment
has no impact, because the TIPS are safely ensconced in a tax-deferred
or tax-free account.
Putting
TIPS into retirement accounts makes sense anyway, because one
of investors' main concerns should be
protecting their retirement nest eggs against inflation. So
TIPS and tax-advantaged retirement accounts are a good match.
TIPS
can also be held in taxable accounts, but this generally isn't
advisable unless you're in a very low tax bracket (like the 0 percent
or 10 percent bracket). If you insist on holding TIPS in a taxable
account, the cash interest payments and principal adjustments are
exempt from state and local income taxes ... at least that's a plus.
Key
Point: Another good reason to not
hold these investments in taxable accounts is to
avoid the complicated original issue discount (OID) rules that
potentially apply whenever marketable debt securities, including TIPS,
are purchased at a discount.
How
to Buy: The minimum face value
for TIPS Notes and Bonds is $1,000. Larger denominations are available
in $1,000 increments. TIPS can be easily bought and sold in the
secondary market through your broker, with commission charges that are
generally reasonable. Transactions can be handled over the phone in
just a few minutes. Also, several mutual funds are now devoted to
investing in TIPS.
Finally,
TIPS can be purchased upon original issue directly from the government
through the Bureau of the Public Debt's online Treasury
Direct program, which does not
involve commission charges. Click here
for more information. However, Treasury Direct is available only for
taxable accounts.
Another
Inflation-Adjusted
Option: I Bonds
Beyond
TIPS, there's another type of inflation-protected U.S. Treasury
security: Series I U.S. Savings Bonds (or I Bonds).
I Bonds earn interest for up to 30 years or until redemption, whichever
comes first, and receive favorable tax treatment. The investor
doesn't owe tax for the accrued interest until the I Bonds
mature or are redeemed for cash. So the federal income tax bill on I
Bond interest can be deferred for up to 30 years. As a bonus, I Bond
interest is completely exempt from state and local income taxes. (The
same is true for EE Bonds.)
Unlike
TIPS, I Bonds are mainly intended for small investors. Also unlike
TIPS, I-Bonds cannot
be held in tax-advantaged retirement accounts (the same is true for EE
Bonds).
Specifically,
paper I Bonds can be purchased at face value at most financial
institutions in the following denominations: $50, $75, $100, $200,
$500, $1,000, $5,000, and $10,000. Electronically held I Bonds can be
purchased direct from the government over the Internet. Click here
for more information.
The
maximum annual investment is $30,000. They can be redeemed for cash any
time 12 months after purchase or later. However, redemptions within
five years of purchase are hit with a penalty equal to three month's
worth of interest.
Here's
where the inflation-protection part comes in. The I Bond's interest
rate is composed of two separate rates:
- A fixed
rate of return determined at issue that applies for the entire 30-year
life of the Bond and
- A variable
rate of return equal to the current inflation rate, which is
redetermined on a semiannual basis.
In
computing the fixed part of the rate, the I Bond principal is increased
to account for inflation. When all is said and done, the current annual
rate, including the semiannual
inflation adjustment, is 3.74
percent for all I Bonds issued between 5/1/07 and 10/31/07.
To
summarize, there are a couple of I Bond advantages. First, they qualify
for favorable tax treatment. Second, they can be purchased in small
denominations, which makes them ideal for small investors, like kids
saving for college.
Remember to store paper I Bonds in a secure place such as a safe
deposit box.
A Third
Inflation-Adjusted
Option: Equity Indexed Annuities
Equity
Indexed Annuity
Basics
Equity
Indexed Annuities are Insurance Company Products. Tare ANnuities, which
means they accumulate earnings tax-free, but are taxed upon
distribution. Usually, the sannuity is tied to a standard stock index,
such as the S&P 500. If during a year the
Index declines you lose nothing. If the Index increases, you get the
increase (capped at a certain percentage.) For example, if you start
with 100, and the Index declines by 20, you still have 100. In the next
year if the Index increase by 10, you have an increase, such as 8, or a
total of 108. If you had a plain stock investment, at the end of year 1
you would have 80 (100-20) and in year 2 you would have 88
(80 +10%.)
Another Option:
Build Amercia Bonds
Build
America Bond
Basics
Build America Bonds similar yields to corporate bonds. The
advantage is they are relatively safe for the principal and
are less of a default risk than lower-rated
corporate bonds.
Build America Bonds, or BABs, are similar to municipal bonds
but they generate is taxable for federal tax purposes.
Types of BABs. :
- With the
first type, the federal government
gives BAB issuers a subsidy equal to 35 percent of the interest they
pay investors for buying the bonds. The subsidy is what allows issuers
to offer interest rates competitive with those of
less-than-investment-grade corporate bonds. For example, California
issued a slew of BABs with a very attractive 7.4 percent interest rate.
With the federal subsidy, the state only has to pay 4.8 percent of that
interest. It can keep the rest.
- With the
second type, the federal government
gives BAB
holders
a tax credit equal to 35 percent of the annual interest
they
earn on the bonds. If a bondholder's tax liability is too low to
qualify for the credit, he or she can carry it over to the next tax
year.
Build
America Bonds are extremely popular among
state and local governments, because the federal subsidies lower their
borrowing costs. The higher return is good for those loking for income
with government protection.
If
you have any questions about Inflation-Proofing your
portfolio, call Ronald J. Cappuccio, J.D.,
LL.M.(Tax) at
(856) 665-2121.
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