tax efficient safe investments?

Question

I have a large sum of money in CDs and savings now. We do not want to invest that money in stocks as we do not want to take any risk with that money. But I am paying 30% tax on the interest every year. Is there any way I can save some taxes while keeping the safety of the investment. I already maxout on my 401K and IRA. I have one kid and make annual contributions to his 529. Can I transfer some money in his name and reduce my taxes?

Answer 1

You might want to look into annuities, which let your interest grow tax-free until you withdraw it. They are designed to allow you to realize a specified amount of income during retirement; you buy what you think you need. It's the opposite of a 401(k), which is a guaranteed-contribution fund (meaning that you know how much will go into it); annuities, like classic pension plans, are guaranteed-benefit funds (meaning that you know how much will be paid out of it, like an old-fashioned pension).

Another option is the tax-free municipal bond. Basically, muni bonds are set up so that the income is tax-free for as long as you hold the bond. If you can set up a tax-free muni as a DRIP (dividend re-investment program), your interest/dividends are tax-free. And bonds tend to fluctuate a lot less than the stock market, although they also tend to lose value during times of inflation. The down side is that the returns tend to be fairly small; you may be able to do better by picking a high-yield taxable investment and just paying the difference. It depends on what bracket you're in versus what the tax-free muni actually pays.

A 529 is good, but limited to $2000 per child per year (I have one child in college and two more on the way...) It is, however, a great way to save for your child's college and reduce your current tax burden at the moment.

One other area I'm just learning about is the UGMA and UTMA Custodial Account. (I've included a URL about them in the Sources area, below.) The salient sentence from the URL I include below (from fairmark.com) is the one that says, "In short, although there is a potential income tax advantage in using an UGMA or UTMA account, the benefit usually isn't large enough to be worthwhile unless the account fits in with your gift plans generally." I'm not sure yet whether this fits with my needs, or if this is more necessary to the yacht-and-polo-pony set. (Yeah, I'm well into the top quartile of US investors, but considering that 75% of Americans have less than $67,000 saved for retirement, that's not that difficult...)

Something I've been looking into, and so far the results look promising: Take out a loan on your 401(k) -- for some useful purpose, of course, like a home remodel or other highly-leveraged use of the funds -- and pay it back as per the terms of the loan. Yes, you pay it back with after-tax dollars; however -- and here's the brass ring -- although the payments you make are OVER AND ABOVE your maxed-out 401(k) contributions, the INTEREST you make on the payments is sheltered from taxes. I'm SURE there's some catch somewhere; it's one of those things that sounds too good to be true -- they always turn out to be, if you look hard enough...

I'm currently looking into using loans on my 401(k) to fund my IRA and my other kids' Coverdell accounts every year. It seems like a win-win: my employer pays something like 40% of the funds I use to buy my IRA, I get to deduct it from my annual income, my retirement builds faster, and life appears to be good. Sure, I have to use after-tax dollars to repay the 401(k) loan, but I get $1000 of tax benefit THIS year from every $600 of LAST year's pre-tax dollars, and the interest the money earns isn't taxed till I retire (and while my FI's 401k investments aren't doing quite what they were this time last year, we're still beating the S&P and NASDAQ indexed funds; I'm crying all the way to the country club, if you will).

I've talked this over with one fairly savvy MBA-holding friend and it seems to be a win, but I haven't done all the math myself. If it works out to be a good idea, remember, you heard it here first. :-)

Answer 2

The one other investment I can think of to lower the taxes on your returns would be municipal bonds (munis). Check with your brokerage or search the Internet on more information about these.

Even though munis might not be taxable federally, the state where you live might take a cut, but that would still be better for your financial goals than paying both federal and state.

Answer 3

Munis - or maybe a US savings bonds (don't pay interest until you redeem the bonds)

You can gift to your child, but talk with a tax adviser first about any gift tax consequences.

Answer 4

If you aren't willing to take more risk than your CD's, then you options are very limited. Since your tax-advantaged accounts are allready maxed, your best bet is US government securities.