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 ow can you invest to take advantage
of the benefits of deferring income? Here are some readily-available investments you can
use.
- Treasury Bills. If you want short-term deferral of income, owning U.S. Treasury
bills that mature after December 31, 1997, can help you. Since Treasury bill interest is
not taxed until the Treasury bill matures, you would
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be able to defer the recognition of this interest by one tax year. If you think you'll
be in a lower tax bracket next year, this strategy would allow you to incur the tax on the
interest at a lower rate.
- Savings Bonds. You can get a longer-term benefit from the purchase of U.S. Series
EE savings bonds. You can choose to recognize the income from these bonds, which are
purchased at a discount, in the years in which the bonds are cashed. As the holding period
required to receive the minimum guaranteed interest is longer term, you can defer the
income for a longer period if the bond is held to maturity.
- Series EE Bonds Issued After May 1, 1995. The interest rules for Series EE bonds
issued after May 1, 1995, and for those issued earlier are summarized in Table 6-1 below.
Table
6-1
Savings Bonds Interest Rules |
Interest |
Older Bonds |
Bonds Issued
After 5/1/95 |
| Years 1-5 |
Bonds earn guaranteed rate. |
Bonds earn short-term rate that is 85% of an average six-month Treasury
security. |
| Years 5+ |
Bonds earn 85% of the average yield of five-year Treasury notes, or a
guaranteed minimum. |
Bonds earn 85% of the average yield of five-year Treasury securities. |
Interest
Credited |
Monthly |
Every six months.
New rates are announced May 1 and Nov. 1. |
Thus, when you own bonds issued after May 1, 1995, you bear the risk if interest rates
fall and you could also lose as much as five months of interest if you cash in the bonds
before the interest is credited.
- Life Insurance Policies. Whole life, variable life, and universal life policies
generally provide for tax-free accumulation of investment funds over long time periods.
Life insurance policies are not appropriate for short-term investing, because of
substantial up-front sales costs and surrender charges. You have two basic options if you
want to have access to life insurance cash values during your life. First, you can cancel
the policy, terminate its protection, and receive the cash value. Second, if you want to
continue the policy, you have access to the cash by borrowing from the insurance company
against the cash value (typically at favorable nominal rates: 5% or 6% on older policies
and 8% on newer policies). Depending on the policy's terms, the loan may or may not
trigger tax on the earnings in the contract.
Unlike other types of loans, however, no repayment is required. You may even choose not to
pay the interest and instead have the interest amount added to the amount of the
outstanding loan. In any event, the loan is ultimately taken into account by a reduction
in the proceeds at your death or a reduction of cash surrender value at surrender. If you
do not pay the interest, you are not entitled to an interest expense deduction. If you do
pay the interest, you may be entitled to a deduction.
- Annuities. Annuities are cousins of life insurance policies. In a
typical annuity contract, the insurer agrees to make payments to you as long as you or a
designated beneficiary lives, sometimes with a fixed minimum number of years.
- The Accumulation Phase and the Payout Phase. With the deferred annuity,
there is an accumulation period during which income is earned on a tax-deferred basis.
This tax-deferred compounding growth is an attractive feature that makes the annuity a
suitable investment vehicle for many people planning retirement. This tax-deferral feature
is especially valuable in a period of higher tax rates.
Most annuities require you to begin the payout phase by a certain age, often 65. If you
withdraw funds from an annuity before age 59½ without annuitizing (exceptions exist for
death and disability), there is a 10% penalty tax on the taxable portion of an amount
withdrawn in addition to the regular income taxes. If you do not expect to face higher tax
rates, a lump-sum settlement could be better.
- Other Features to Consider. Unlike most life insurance policies,
annuities usually have no up-front sales charges. However, they do have significant
surrender charges if you decide to cash in your contract. These charges normally decline
over time and disappear after six to eight years. Surrender charges are often waived if
the policyholder dies.
Although you cannot borrow against your annuity, most insurers permit you to withdraw
up to 10% of the accumulated value per year without paying a surrender charge. This is an
attractive feature since it allows you to draw on funds as needed without making the
irrevocable decision to annuitize the contract. Of course, ordinary income taxes and early
withdrawal tax penalties could still apply.
Both life insurance and annuities are complicated arrangements involving many provisions
and factors. Before you make a withdrawal or take out a loan in relation to either, you
should discuss the effects of these actions with your insurance and tax advisers.
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