10 Ways to Invest Tax Free (Forbes)

10 Ways to Invest Tax Free (Forbes)

William Baldwin, Forbes Staff

Taxes|2/10/2011

For the moment, taxes on portfolios are modest. The federal rate is 15% on most dividends and on long-term capital gains. Come 2013, though, the rates shoot up.

Without a law change, the maximum federal tax on interest, dividends and short-term gains will go to 44.6%. That consists of a 39.6% stated rate, the 1.2% cost of a deduction clawback and a 3.8% surtax to pay for health care. The max for long gains will be 25% (but 23% for assets held for more than five years). Add state taxes to all of these.

What’s an investor to do? Take defensive measures. Here are ten ways to pocket investment income without paying tax on it.


Set up a kiddie Roth


Did your daughter earn $4,000 last summer that she needs for college? Were you going to leave her at least $4,000 in your will? Start your bequest now. Hand her $4,000 that she can use to fund a Roth IRA. Tell her not to touch it until she is 60.

She’ll get 40 years of tax-free compounding. (At 7% a year, this would turn $4,000 into $60,000.) You’ll get money out of your estate, probably saving on state inheritance taxes.

.

Buy an MLP

Master limited partnerships that own energy assets like pipelines tend to pay pretty good dividends (in the neighborhood of 5%). Those dividends, at least initially, are largely sheltered by depreciation deductions. The quarterly cash, that is, is considered a nontaxable “return of capital.”

After a decade or two this tax shelter is exhausted, but if you die owning these shares your heirs get to start the process over with a new, higher tax basis.

Go Ugma

Use the Uniform Gift to Minors Act (a.k.a. Uniform Transfers to Minors Act) to set up a brokerage account for your son or daughter. The first $950 of annual income is free of tax; the next $950 is taxed in the kid’s low bracket.

The downside is that at age 18 Junior takes ownership and might not spend the money on college, as you intend. So fund the account modestly­—$30,000 is plenty—and concentrate the holdings on investments that (a) generate a lot of taxable income and (b) are compelling additions to the overall family portfolio. The idea is to make full use of that $1,900-a-year shelter while parting with a small amount of capital.

Here are several examples of investments that make sense in a diversified portfolio and that spew out a lot of ordinary income:

–exchange traded funds that hold a lot of Ginnie Maes and the like (MBB) or the whole bond market (BND).

–the ETF for junk bonds (JNK).

–high-yielding blue chips like Verizon, AT&T and Pfizer.

–preferred stocks.

Two cautions. (1) To avoid gift tax wrinkles, limit each year’s contribution to $26,000 per child ($13,000 if you are single). (2) Don’t set up Ugmas if you think your kid will qualify for college financial aid. Any assets in the kid’s name will be snatched by aid officers.

.

Open a 529

A Section 529 plan lets you accumulate investment income tax free, provided the proceeds are used on schooling. Drawback: Sometimes stiff fees erase the income tax saving.

The account is likely to be a good idea where the costs are low (as in Utah) or there’s a break on state income tax for parents chipping money in (as in New York).

As with Ugmas, 529s are not a good idea for families likely to get tuition assistance.

.

Own commercial real estate

As long as your building doesn’t have too much of a mortgage, depreciation deductions will make a good chunk of your rental income free of current income tax. There’s more on the economics of these deals here.

.

Own muni bonds

Interest on the general obligations of state and local governments is free of federal income tax. In most states you also get a pass on state income tax for home-state bonds. Caution: Some states are in financial trouble. Check out the Forbes Moocher Ratio before buying.

.

Give away stock profits

You put $3,000 into Netflix, wait at least a year, then give away the shares to charity when they’re worth $8,000. You get a deduction for the whole $8,000. Your $5,000 gain is never taxed.

Two other ways to shelter appreciated property from capital gain taxation: leave it in your estate, or give it to a low-bracket relative.

Bequeathed property benefits from a step-up, meaning that gains unrealized by an owner at the time of his death permanently escape income taxation.

Low bracket taxpayers (people who would be in a 25% or lower bracket if all their capital gain were taxed as ordinary income) get a free ride on long-term capital gains. But if the donee is a son or daughter 18 or younger (23 if in school), beware the kiddie tax, which applies to investment income over $1,900 a year.

.

Capture losses

When the market is down, swap out of losing positions into similar but not identical ones. For example, you could exit an S&P 500 index fund and immediately buy the Vanguard Megacap Index Fund. In this fashion, you can run up a capital loss carryforward that will make future capital gains tax free. For more on loss harvesting, go here.

.

Buy a safe


If your $400 investment saves you $45 a year in safe deposit box fees, you’ve got an 11% yield, tax free. The only exception on the tax side would be if you are one of those rare birds in a position to deduct miscellaneous items like the rental on a strongbox to hold your gold coins. Miscellaneous deductions are usable only to the extent they exceed 2% of your adjusted gross income; not many taxpayers get anywhere near this threshold.

.

Be a cheapskate investor

Are you paying someone 1.5% a year to have your assets managed? Cut this cost in half by haggling. A dollar saved in this fashion is a dollar earned free of tax, unless you are claiming miscellaneous deductions, which is unlikely.


--------------------------------------------------------------------------------

This article is available online at:
http://www.forbes.com/sites/baldwin/2011/02/10/ten-ways-to-invest-tax-free/
America's Most Promising Companies

The Back-door Roth IRA ( from Natalie Choate, ataxplan.com)

How to get around the Income Limit for Roth IRAs

Question: If a high-income taxpayer makes a nondeductible IRA contribution, is he free to convert it to a Roth IRA immediately? Or would this be deemed an excess Roth conversion if done in the same year?

Natalie: He is free to convert it immediately. It would not be deemed an excess Roth IRA contribution. There's no legally required waiting period; however, it would make sense to wait until you have received adequate documentation that the original contribution was made to a traditional IRA, just so the record is absolutely clear.

For some reason, Congress left income limits in place for making "regular" (annual-type) contributions to a Roth IRA, even though they removed the income limit for conversion contributions. So this sequence (contribute to a traditional IRA, then immediately convert the account to a Roth) will be very popular with everyone who (1) wants to make a regular contribution to a Roth IRA but is ineligible to do so and (2) is eligible to contribute to a traditional IRA. To be eligible to make a regular contribution to a traditional IRA you must have compensation income at least equal to the contributed amount and be younger than age 70½ as of the end of the contribution year.

As a reminder, the fact that the participant is converting a newly-created IRA (funded with a nondeductible contribution) does not mean that the conversion is automatically "tax-free." The conversion of a newly-created traditional IRA is taxed just like the conversion of any other traditional IRA; you do not look only at the pre- and after-tax money in the particular account he happens to be converting.

The nontaxable portion of any IRA conversion (whether of a brand new account or an IRA you've held for years) is determined the same way. You multiply the converted amount by a fraction. The numerator of the fraction is the total amount of after-tax money the participant has in all of his traditional IRAs. The denominator is the total combined value of all of the participant's IRAs. The amount that results from applying this fraction is the only amount that you can treat as the tax-free conversion of after-tax funds-regardless of which account the conversion actually came from.

Example: Fred and Ed each make nondeductible $5,000 contributions to their respective newly created traditional IRAs on Monday, March 1, 2010. A week later, each of them converts his newly created $5,000 traditional IRA to a Roth IRA. Even though they both followed exactly the same steps, they have very different tax results.

For Fred, the newly created $5,000 traditional IRA is the ONLY traditional IRA that he owns. Fred's conversion is "tax free" because he's converting 100 percent after-tax money.

Ed, on the other hand, in addition to his newly created $5,000 traditional IRA, also owns a $95,000 rollover traditional IRA. The rollover IRA is 100 percent pretax money. To determine how much of Ed's 2010 conversion is tax-free, we multiply the $5,000 conversion amount by the following fraction:

$5,000 (that's the total of Ed's after-tax money in both of his traditional IRAs)
$100,000 ($95,000 + $5,000; the total combined value of all Ed's traditional IRAs)

$5,000/$100,000 times $5,000 = 5%, meaning that only $250 of the $5,000 conversion is deemed to come from the after-tax money in Ed's IRAs. The other $4,750 of his conversion is included in his gross income.

I have simplified the fraction for purposes of illustration; it's actually based on year-end values.

So yes the strategy is legal and safe and it works--but don't fall into the trap of thinking the conversion is automatically tax-free just because you are converting a new account funded only with nondeducted contributions.
Resources: See Chapter 2 of the author's book Life and Death Planning for Retirement Benefits for how to compute the taxable and tax-free portion of any distribution; $89.95 plus shipping at www.ataxplan.com or 800-247-6553. For complete explanation of all aspects of Roth IRAs and other Roth retirement plans, get Natalie's 97-page Special Report Roth-Ready for 2010!, downloadable for $49.95 at www.ataxplan.com.

Is Converting to a Roth IRA for You? (WSJ)

RETIREMENT PLANNING
DECEMBER 6, 2009
Get Ready for 2010—the Year of the Roth IRA

By ANNE TERGESEN
New tax rules are about to give more people access to a Roth individual retirement account, one of the most effective vehicles in which to accumulate money for retirement or heirs.

Roth IRAs are currently off-limits to a whole group of people. Individuals with modified adjusted gross income of $120,000 or more can't contribute to one of these accounts. For married couples, the threshold is $176,000. And individuals with modified adjusted gross income of more than $100,000 and married taxpayers who file separate returns are barred from moving assets held in traditional IRAs into Roth IRAs.



But starting Jan. 1, Uncle Sam will permanently eliminate both the income and filing-status restrictions on transferring money from a traditional IRA to a Roth -- a procedure known as converting. So, anyone willing to pay the income taxes due upon making such a move will be able to funnel retirement savings into a Roth, where it can grow tax-free.

Money When You Want It
Under the new rules, high-income taxpayers who wish to contribute to a Roth IRA are still out of luck: Income limitations on funding these accounts will remain in effect. However, Uncle Sam's decision to allow high earners to convert will give these individuals a back-door way to fund a Roth on a continual basis.
How so? Each year, these taxpayers can open a traditional IRA (which has no income limits) and contribute the maximum (currently, $6,000 for individuals age 50 and older) on a pretax or aftertax basis. Then, they can convert the assets to a Roth IRA.
Why bother with a conversion? Roths have several advantages over traditional IRAs.

Perhaps the biggest one concerns taxes -- or a lack thereof. For the most part, withdrawals from Roth IRAs are tax-free as long as an account holder meets the rules for minimum holding periods. If you convert assets to a Roth from other IRAs or retirement plans, you have to hold those assets in a Roth for five years, or until you turn age 59½, whichever comes first, to make penalty-free withdrawals on your converted amounts. Each conversion has its own five-year clock.

Another benefit: no required distributions. With a traditional IRA, individuals are required to begin tapping their accounts -- and to pay taxes on those withdrawals -- after reaching age 70½. Roth accounts aren't subject to mandatory distributions, so the money in a Roth can grow tax-free for a longer period of time.

If you are planning to leave your IRA to heirs, Roths have yet another advantage. Although people who inherit both traditional and Roth IRAs must make annual withdrawals from those accounts (based on their life expectancies), Roth beneficiaries owe no income tax on the money.

Tax Bill Upfront
Still, there is a cost to converting to a Roth -- namely, the income-tax bill. When you withdraw money from your traditional IRA, you will have to pay income tax on the withdrawal, or, more precisely, on the portion of it that represents pretax contributions and earnings.
In 2010, Uncle Sam is offering taxpayers who convert a special deal: They can choose to report the amount they convert on their 2010 tax returns, or they can spread it equally across their 2011 and 2012 returns. (If you are worried that Congress may raise tax rates, consider paying the tax bill in 2010.)

To determine whether it makes financial sense for you to convert, it's important to consider various factors. For example, converting may be the right move if you expect to pay higher future tax rates or if the value of your IRA account is temporarily depressed, says Ed Slott, an IRA consultant in Rockville Centre, N.Y. In either case, by converting to a Roth today you'll lock in a lower tax bill than you would otherwise pay.

To estimate your potential tax bill, first calculate your "basis." Expressed as a percentage, this is the ratio of two numbers: aftertax contributions you have made to your IRAs (if any), and the total balance in all your IRAs.

For example, if you contributed $40,000 aftertax to your IRAs and have a total of $250,000 in those accounts, your basis would be 16% (or $40,000 divided by $250,000). As a result, if you plan to convert $100,000 to a Roth, 16% of that $100,000 (or $16,000) could be transferred tax-free.

Another factor is how long you can afford to leave the money in a Roth. Because the Roth's major advantage lies in its ability to deliver tax-free growth from age 70½, the longer you can afford to forego withdrawals, "the more converting plays to your advantage," says Aimee DeCamillo, head of personal retirement solutions at Merrill Lynch Wealth Management.

Before pulling the trigger, speak to a financial adviser. You also can crunch the numbers using online calculators at sites including RothRetirement.com and Fidelity.com/rothevaluator.

Maximize the Benefit
If you determine that it pays to convert, the following strategies can help you maximize the benefit:

Financial experts say it's ideal to have money to pay the taxes due upon conversion from a source other than your IRA. That allows you to retain a bigger sum in your tax-sheltered retirement plan.

Keep in mind that you don't have to convert your entire IRA. It might make sense to do it piecemeal, as you can afford it, over a number of years.

Put converted holdings into a new account, rather than an existing Roth. That way, if the value falls after you've paid the tax bill, you can change your mind, "recharacterize" the account (meaning you move the money back into a traditional IRA) and wipe out your income-tax liability.

You have until Oct. 15 of the year following the year of conversion to recharacterize. For example, if you were to convert your IRA to a Roth in 2010, you would have until Oct. 15, 2011 to recharacterize it. Later on, you could choose to convert the assets to a Roth again.

Better still: Consider opening a separate Roth for each type of investment you hold. That way, you can recharacterize the ones that perform poorly and leave the winners alone.

Write to Anne Tergesen at anne.tergesen@wsj.com

Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved

401k: when it makes sense to opt out (Forbes.com)

The 401(k) Rethink
from Forbes.com
David K. Randall, 09.07.09, 12:00 AM ET


Millions of company employees are being automatically enrolled in 401(k) plans. That's great news for fund firms but not necessarily for workers.
Aware that Americans weren't putting away nearly enough to support themselves comfortably in old age, Congress enacted legislation three years ago that permits employers to automatically enroll workers in 401(k) savings plans. Workers would have to opt out rather than opt in. Inertia would work in favor of savings.

At companies adopting the forced-march approach, employees have 3% to 6% of pretax wages diverted from their paychecks unless they go to the trouble of explicitly informing their employers that they do not want to participate. Of employers with at least 1,500 employees, half now have automatic enrollment plans.

In one sense the legislation is working like a charm. In 2005, just before Congress began encouraging automatic enrollment, seven in ten eligible workers participated in 401(k) plans. Now nine in ten do among companies with automatic enrollment. What's more, over half of those automatically enrolled are either younger than 34 or making less than $40,000 a year, Fidelity Investments says.

What's not to like? Not a thing, if the goal is merely to boost 401(k) assets. Plenty, if the objective is to help workers save for retirement in the most effective way possible. That's because in the current environment 401(k) plans are a crummy deal for millions of workers. That goes doubly for young and low-wage earners. Following are some guidelines to consider before enrolling yourself, or your workers, in a 401(k) plan.
The Big Chill

Conventional wisdom has long had it that only a fool would fail to contribute to a 401(k), at least up to the point that his employer stops matching his contributions. Passing this up, the adage goes, is tantamount to leaving free money on the table.

That logic still holds if your employer offers a match. Unfortunately 5% of employers have frozen 401(k) contributions in the past year. In the absence of matches, and in light of the points below, a 401(k) might not make sense at all.

Better Alternatives

For workers in low tax brackets it may make more sense to put aftertax dollars in now and take them out tax free later in life via a Roth 401(k). That's assuming your employer offers this relatively new type of retirement account and attractive investment options inside it. For both types of 401(k)s, the contribution limit is $16,500 this year, or $22,000 for those age 50 and above.

And what if your employer has a no-match 401(k) but no Roth option? If you are in a low tax bracket, you might do well to opt out of the 401(k) and put the money instead into your own Roth Individual Retirement Account up to the $5,000 maximum for 2009 ($6,000 for those 50 and over). An IRA enables you to call the shots on where your money is invested. That means you can select an index fund or ETF with rock-bottom fees or go farther afield than most 401(k) plans allow and into things like real estate investment trusts or commodity futures. Single filers with modified adjusted gross incomes of less than $105,000, or married couples filing jointly and together earning $166,000 or less, can contribute to a 401(k) and make a full contribution to a Roth IRA. After that a Roth is limited or not allowed.

Younger workers in particular can benefit from funding a Roth IRA. As with a Roth 401(k), with the Roth IRA dollars go in after taxes are paid but come out tax free in retirement, when income, and income tax rates, are likely to be substantially higher.

"You have to factor in that you may have a lower tax bracket now than when you retire," says Mickey Cargile, head of WNB Private Client Services in Midland, Tex.

The Roth IRA also enables you to take out contributions at any time without paying a penalty, which can be useful for buying a house, sending a child to school or covering expenses between jobs. Withdraw money from a 401(k) before you turn 591/2 and you'll pay a 10% penalty, plus ordinary taxes.

Risky Investments

After Congress passed automatic 401(k) enrollment, the Department of Labor drafted guidelines stipulating that employers can exempt themselves from legal claims of negligence by designating target date funds as their default investment vehicles. These funds wrap together other funds that invest in stocks, bonds and money markets with the aim of buying risky assets early in participants' careers and becoming more conservative as they near retirement.

Target date funds have proved a disaster in the recent financial crisis. Some that were sold to those planning to retire in 2010, and marketed as geared toward capital preservation, were heavily invested in stocks and lost 40% of their value last year. The Senate is investigating.

Under the law, employers have a fiduciary duty to offer employees prudent investment options. The problem is that as long as they go along with what other employers are doing it will be hard to argue that they were imprudent--even if everyone's 401(k) loses a significant portion of its value.

"No matter what Wall Street has persuaded Congress to do, the only safe investment that people should be defaulted into are Treasury Inflation-Protected Securities," argues Laurence Kotlikoff, an economics professor at Boston University. "People shouldn't have Big Brother taking risks for them."

Academics warn that a false sense of security is another risk in making it too easy for employees to save for retirement. Workers who invest in a 401(k) without lifting a finger are unlikely to spend much time looking into whether they're saving enough, frets Punam Anand Keller, a professor of management at Dartmouth's Tuck School of Business.

"People assume it's like Social Security, and that once they're enrolled, nothing happens to that money," says Keller. "It's a false assumption."




--------------------------------------------------------------------------------

Fee Fiascos

Whether you're enrolled automatically or not, once you're in a 401(k) there's no cap on how much the plan might skim off the top in fees. As FORBES pointed out recently ("Group Stink"), many plans, especially those sold to small companies, can eat up roughly half of real investment returns. (That's not hard to do. Your assets might return 4% after inflation and an expensive asset manager can take 2% of assets annually.) Many small company plans offer dubious investment options, like deferred annuities that charge insurance premiums but offer little in the way of benefits.

Companies that automatically enroll workers have a fiduciary obligation to ensure that fees are reasonable, says Jeffrey Martin, a tax expert at Grant Thornton. "But 'reasonable' is a subjective determination," he adds.

Among 26 target date funds aimed at workers who plan to retire in 2045, expense ratios range from a modest 18 cents per $100 invested at Vanguard to $1.53 at BlackRock.

"I don't know how many people look at fees in their accounts now. That's what the mutual fund industry is relying on," says Glenn Sulzer, a tax attorney with CCH in Chicago.

In the end, automatic enrollment is a greater boon to the mutual fund companies who stand to receive billions of dollars in automatic contributions than it is likely to prove to individual savers, says Boston University's Kotlikoff.

"The money is locked in and big mutual fund companies earn fees on it year after year without having to do any work," he says. "This whole structure doesn't guarantee financial security or retirement security."

Decisions, Decisions

It's usually a good idea to invest in a 401(k), as long as your employer is matching your contributions. If it's not, other alternatives may be preferable and offer more flexibility to invest or to make penalty-free withdrawals before you retire.

Source // Contribution limit // Highlights
401(k) // Employer $15,500/$20,500 if older than 50 //Contributions pretax; employer may match contributions

Roth 401(k) // Employer $15,500/$20,500 if older than 50 //Employee contributions taxed now; employer match taxed at withdrawal

IRA / Self-directed $5,000/$6,000 if 50 or older // Withdrawals taxed in retirement

Roth IRA / Self-directed $5,000/$6,000 if 50 or older // Contributions taxed now; some taxpayers with higher incomes can't contribute


Income refers to adjusted gross income. Source: CCH.

Obama Kids Tax Shelter 529 College Plan (WSJ)

FAMILY FINANCES APRIL 18, 2009

Obamas Pump Up College Savings
Parents Make Big Upfront '529' Investment for Their Daughters' Tuition
Article

By JANE J. KIM
Malia and Sasha Obama's college education appears to be taken care of in a massive contribution that the president and first lady made to a "529" college-savings plan in 2007.

But like everyone else, they have likely suffered big losses.

According to their 2008 tax returns, the Obamas took advantage of a unique feature of 529 plans that allows account owners to front-load five years' worth of contributions, $240,000 in total for the two girls. They did so without triggering gift taxes -- now levied on any gift exceeding $13,000 a year. Form 709, the federal gift-tax form, shows that Barack and Michelle Obama made equal contributions of $120,000 each, or $60,000 to each of the two children in 2007.

Senate disclosure forms released last year show that the contributions were made to Illinois's adviser-sold Bright Directions College Savings Program, in two age-based growth portfolios, which are designed to become more conservative the closer the child is to attending college. Assuming that the Obamas haven't changed their investments, one of those portfolios has lost roughly 35% in the past year through March, while the other one is down about 27%.


The filings offer a peek into how the Obamas are planning to pay for college for their daughters, Malia, now 10, and Sasha, seven. College tuition has soared in recent years, with average tuition and fees at private four-year colleges hitting $25,143 for the 2008-2009 academic year, according to the College Board. Meanwhile, average in-state tuition and fees at four-year public universities jumped to $6,585, up 6.4% from the previous year.

In recent years, tax-advantaged 529 plans have become a popular college-savings vehicle for many parents. In a 529 plan, savers put after-tax dollars into an account that typically offers a wide range of mutual funds.

Distributions and earnings are tax-free as long as they are used for higher education. Investors can invest in any plan, although they may get an additional state tax break if they invest in their own state's plan. The Illinois 529 plan, for example, offers a state-tax deduction for contributions.

A spokesman for the White House confirms that a payment was made in 2007 and that the payment, for reporting purposes, will be prorated over five years.

By front-loading five years' worth of contributions, the Obamas also are cutting possible future taxes on their estate since they have gotten $240,000 -- and any future appreciation on that amount -- out of their estate, says Tom Ochsenschlager, vice president of taxation at the American Institute of Certified Public Accountants, or AICPA.

To be sure, not every family has the means to sock away as much money into 529 plans. The five-year gift election is typically used by wealthy individuals or grandparents who want to help pay for college while reducing their taxable estates, says Joe Hurley, founder of Savingforcollege.com. "Most parents don't have that kind of money to put in all at once."

While the Obamas' investments are down with the bear market, there is a silver lining for investors in these plans. Investors who are underwater can liquidate the plan without penalties or taxes. Losses can be claimed as a miscellaneous itemized deduction, which can help reduce investors' taxes to the extent those deductions exceed 2% of their adjusted gross income, Mr. Hurley notes. Those who are in the alternative minimum tax, however, are out of luck since miscellaneous itemized deductions aren't usable under the AMT.

Write to Jane J. Kim at jane.kim@wsj.com

Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved