How To Protect Your Income From The I.R.S.

Taxes can chomp away a third or more of your income. Here are some investments that can help eases your tax bite.

a tax-deductible Keogh, or up to 13% of your income in a SEP, which is similar to an IRA. (See “Financial Savvy for the Self- Employed,” September 1996.)

MUNI BONDS AND UITs
If you’re concerned about the double whammy of federal and state taxes, you should consider municipal bonds (munis) or unit investment trusts (UITs), especially those issued by your home state.

Muni bonds are debt obligations issued by city, state or local government agencies. Interest paid on municipal bonds is tax-free at the federal level. If you reside in the state or locality issuing the bond, then it’s also free from state and local taxes. However, interest on Treasury securities is tax-free at both the state and local levels. Depending on your age and salary, muni bonds may not be for you. “Unless you are in the 31% tax bracket, munis really don’t pay,” says Patrick.

Let’s assume you’re in the 15% tax bracket and trying to decide beween tax-free municipal bond paying 5% and a Treasury bond paying 7%. Which deal is better?

In this case, the effective tax-free yield of the municipal bond equals 5.9%. Here the 5% municipal bond is not nearly as attractive as the taxable Treasury bond yielding 7%. But it’s a different story when your tax bracket is 31%. Now, the effective tax-free yield is 7.2%. Also remember that the yield spread between taxable bonds and tax-free bonds widens and narrows as market conditions change.

When shopping for munis, “look for triple A-rated bonds, which means the issuer has insurance coverage on the bond or a pool of assets to ensure payment in case of default,” advises D’Aguilar. Check with rating services like Standard & Poor’s.

Remember th
at the income on a bond is fixed, so you may lose money if your investment doesn’t keep up with inflation.

Selling a muni before maturity when rates are rising subjects you to risks as well. To guard against these ups and downs, D’ Aguilar suggests that you buy into a muni bond fund or UIT, both of which cushion your investment with a diversified portfolio.

A muni fund is basically a mutual fund that invest solely in municipal bonds. A UIT differs from a bond fund in that it’s not actively managed. Unit trusts issue a predetermined number of shares or units; the fixed portfolio of securities in a tax-free UIT differs from a bond fund in that it’s not actively managed. Unit trusts issue a predetermined number of shares or units; the fixed portfolio of securities in a tax-free UIT are selected to achieve specific investment objectives, usually monthly income and preservation of capital.

The initial investment of a muni fund or UIT can be as low as $1,000, and your income is still tax-exempt. Tax-free UITs may be insured or uninsured, and the securities in their portfolios may be chosen to satisfy specific state laws.

VARIABLE ANNUITIES
Variable annuities are most beneficial if you’re about 50 years old and have 15 years till retirement, and are in the 31% tax bracket, says Patrick, Since

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