Investing 401

Developing a solid tax strategy is critical to making sure your profits don't turn into a loss

for long-term investors.” Policyholders can allocate their premiums among various sub-accounts, many of which are similar to mutual funds.

Sharon Barnwell, co-owner and CEO of Caribbean International Shipping, a freight-consolidation company based in Stone Mountain, Georgia, decided to take Baptist’s advice. “My husband, Gordon, and I have a young son so we need the life insurance,” she says. “By choosing variable life and investing in the equity sub-accounts, we expect to build up a significant amount of cash value within the policy.”

A life insurance policy’s cash value is viewed as an investment account: Profits aren’t taxed as long as they remain inside the policy. “I’m hoping to retire in about 20 years,” says Barnwell. “By then, I plan to tap the cash value of the policy, tax-free.” Untaxed policy loans and withdrawals are permitted under current law, if handled carefully.

Ivan Bishop, vice president of product marketing for Pacific Life Insurance Co. in Newport Beach, California, provides the following example: A 45-year-old nonsmoker in good health buys a $500,000 variable life insurance policy and agrees to pay $10,000 per year in premiums. Over the next 20 years, he pays a total of $200,000.

If those premiums are placed into investment accounts that earn 10% per year, before policy expenses when he retires at 65 (a possible outcome), the policy’s cash value will be in excess of $400,000.

“Under these assumptions,” says Bishop, “he can withdraw about $35,000 from the cash value, tax-free, each year. This can go on for nearly six years, until he has withdrawn $200,000, which is the amount he has paid in premiums.”

At that point, he can start to borrow that same $35,000 per year. “This can go on until age 90, with those assumptions,” s
ays Bishop, “gradually reducing the policy’s death benefit from around $500,000 to less than $200,000. However, under those same assumptions, taking $40,000 or more per year from the policy will cause the policy to lapse and result in a large tax bill, so you need to be careful.”

Interest income need not be taxable. You can reduce the taxes you pay on income from bonds as well as from stocks. “Generally, the higher your tax bracket, the more appropriate an investment in tax-exempt municipal bonds will be,” says Cheryl Holland, a financial planner at Abacus Planning Group in Columbia, South Carolina.

You might earn 5% from a Treasury bond, for example, and take home only 3.5%, after taxes, assuming a 30% tax bracket in 2002. In that case, you would receive greater after-tax income from a municipal bond yielding 4%. “If you’re buying municipal bonds,” says Holland, “the longer the time to maturity, the higher the commission to the broker selling the bond. The same may be true for credit ratings. Typically, the lower the quality of the bond, the higher the commission to the selling broker.”

With muni bonds, beware of “too much” tax shelter. If you buy out-of-state municipal bonds, you may pay state income taxes, while locally issued bonds are totally tax-free.

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