Tax-advantaged investing

April 1, 2002
For as little as $500, an individual can invest in a professionally selected mutual fund and gain a substantial amount of diversification.

For as little as $500, an individual can invest in a professionally selected mutual fund and gain a substantial amount of diversification.

By Kathleen Adams, RDH, BS

ertain investments are totally or partially excluded from federal income taxation, allowing you, the investor, to gain more from your earnings. Through tax-exempt vehicles, you may avoid federal income tax on the interest income you've earned and, in turn, reinvest or keep dollars that otherwise would be lost to the IRS.

Municipal bonds are key vehicles in today's tax-exempt market. They are issued to finance public projects that range from construction of highways, bridges, and schools to the repair or improvement of sewer and water systems. Municipal bonds usually are purchased in minimum denominations of at least $5,000. In order to be properly diversified, many experts believe the investor should have a portfolio of about 10 issues – a financial commitment of at least $50,000.

Mutual funds that invest in tax-exempt municipal bonds provide even more benefits than tax advantages alone, including professional management, a high level of diversification, and monthly income. Tax-exempt municipal bond mutual funds offer investors the opportunity to purchase shares in a large pool of municipal bonds with a smaller investment outlay. For as little as $500, an individual can invest in a professionally selected mutual fund and gain a substantial amount of diversification.

Because income from tax-free municipal bond funds is generally federal income tax exempt (however, it may be subject to state or local taxes or the federal alternative minimum tax), rather than merely tax-deferred to a future date, bottom-line earnings may be considerably greater than they would be with a taxable investment. An investor who falls in the 28 percent tax bracket, for example, would need to receive a taxable yield equivalent to 8.33 percent to equal a tax-free yield of 6 percent.

Tax-free mutual funds may be open- or closed-ended, and typically are managed actively. Unlike individual municipal securities, mutual funds usually pay monthly dividends that investors can accept as a monthly check or, in the case of open-ended funds, conveniently reinvest at net asset value. Municipal bond funds also are highly marketable, meaning shares can be redeemed at any time. (Redemption is at net asset value (NAV) at the close of business on the redemption date.)

Professional management

As with any investment that provides periodic payments from a portfolio of interest-bearing securities (known as fixed-income investments), tax-free municipal bond funds are subject to interest rate risk. When interest rates rise, municipal bond values fall. Conversely, if rates fall, bond values rise. Professional management and diversification within the funds may help moderate risks associated with fixed-income investing.

Tax-exempt municipal bond funds may not be appropriate for everyone. Remember, the most important step in forming your investment strategy is defining your personal investment objectives. Having clear objectives in mind – whether tax-free or otherwise – makes it easier to choose the investments that are right for you.

When you pay taxes on your investment earnings, you may be missing some of the rewards of compounding growth. The power of compounding allows you to benefit from returns on your earnings as well as your principal. Through a tax-deferred investment vehicle, such as an annuity, compounding may help your money grow even faster.

An annuity is a contract between you and a legal reserve life insurance company to provide income for yourself or a named beneficiary at a later date, usually during retirement. Because you can shelter your investment earnings from taxes, you may increase their potential for growth.

Tax deferral is one of the main benefits of an annuity. You pay no federal taxes on dividends, capital gains, or interest while they accumulate in your account. And, taxes are due only as you begin receiving payments – typically during your retirement years when you may be in a lower tax bracket. At that time, you pay taxes only on your accrued earnings at the time of distribution along with any untaxed principal.

Because an annuity is tax-deferred and has the power of compounding, it can be an effective way to invest for long-term goals, such as retirement. You may fund your annuity by paying premiums in a lump sum or as a series of contributions over time, depending on the type of annuity you choose. In contrast to IRAs, annuities have no contribution limits, nor is a deduction to gross income allowed.

You may choose between fixed and variable annuities. With a fixed annuity, you are guaranteed a specific rate of interest for a predetermined amount of time, ensuring safety of principal and security against market fluctuations. A variable annuity offers the potential for greater returns while taking on a higher level of risk. You can invest your money within a select group of managed portfolios investing in various types of assets within the annuity. Your return depends on the performance of the portfolios you choose.

When it's time to withdraw from your annuity, you can receive your payments in a lump sum or over a fixed number of years, or you can structure the annuity contract to guarantee monthly payments for life (and your spouse's life also, if you choose). An annuity also offers a death benefit guarantee. If death occurs before payments begin, your beneficiary will receive all payments or the total market value of the account, whichever is greater (less any prior withdrawals, called partial surrenders).

Note: Annuities impose annual policy and other administrative charges, and most contracts have contingent deferred sales charges. Generally, that means if you withdraw funds during the first five to 10 contract years, there may be a fee (see your specific contract). Also, the IRS imposes a 10 percent federal tax penalty if you withdraw funds before age 59, except in certain hardship cases. Such penalties are in addition to paying regular taxes owed.

Kathleen Adams, RDH, BS, is a financial adviser with Waddell and Reed ( She is currently trying to initiate money-management workshops for hygiene students and specializes in working with dental professionals. She can be reached at (800) 210-1357.