As the economy weakens and perhaps enters a recession, you’ll want to act to protect your wealth. Strategies to do so are primarily financial — but have important tax aspects that may make a difference in your situation. Wealth protecting ideas…
Example: “Risk-free” Treasury bills, very-low-risk bank certificates of deposit (CDs), and money market funds now pay only about 1.5% to 2.5% interest, on average, compared with about 5% one year ago.
But many people who are receiving sharply reduced interest income are paying still-high interest rates on consumer loans (such as for car and appliance purchases) and credit cards.
Key: Reducing interest that you pay provides the same cash flow benefit as increasing interest you receive — and cash-flow gains from paying down debt are tax free.
Example: A year ago, you bought Treasury bills for $5,000 that paid nearly 5%. If you reinvest in them now, they will pay only 1.5% — and that’s taxable, so if you are in the 30% tax bracket, you will receive barely over 1% after taxes — about $50.
But if you owe $5,000 of credit card and consumer debt on which you pay an average of 11%, you can eliminate it by cashing in the Treasuries and using the proceeds to pay down the debt, saving $550 of interest. Subtracting interest lost from not renewing the Treasuries, you net nearly 10% after tax — almost $500.
Interest rates on consumer debt today range from high single digits to 25% and even higher on credit cards — you earn that high a rate as a return by paying down such debt.
No investment provides such high, 100% safe, tax-free returns. So boost cash flow by paying down your highest-rate debt with funds that you would otherwise invest or get from cashing in low-rate and risky investments.
Moreover, paying down your mortgage reduces its value to you as a source of tax-deductible financing.
Exception: Many people who have high-rate “jumbo” mortgages have a new opportunity to reduce the rates they pay.
Jumbo mortgages exceed the amount that the Federal Housing Administration (FHA) insures to mortgage lenders, so lenders charge higher rates on them than on FHA-insured loans.
Before this year, the FHA insurance limit on one-family homes ranged from $200,160 to $362,790 ($544,185 in Hawaii), varying by area. But in 2008, as part of the federal fiscal stimulus plan, the limit has been increased to range from $271,050 to $729,750.
Opportunity: If you currently have a high-rate mortgage that was taken out as a jumbo loan when the conforming loan limit was $417,000, you may now be able to refinance it as an FHA-insured loan to lower the interest rate — and save thousands of dollars of interest cost per year. It may also be time to lock in the rate on an adjustable rate mortgage.
Diversification is vital to protecting wealth against risky markets. Investments to consider now…
Examples: Health-care companies, utilities, telecommunication companies, and other firms that retain demand for their products even in down economies.
Dividends now generally are taxed at a low 15% top tax rate. Steady dividends protect the value of a stock and may provide a positive return from it even if the market falls. Firms that pay dividends generally cut them only as a last resort.
Why: Issuers of many municipal bonds obtain an AAA rating for them by having them insured by bond-insurance firms. But the recent difficulties in the credit markets have weakened some of these insurers — dropping the rating of some bonds to AA, causing many investors to flee them, and thus reducing their price and increasing their yields.
Opportunity: This flight is largely excessive — AA bonds backed by government revenue remain a superior credit risk, and some now are in effect paying a yield “bonus,” tax free.
Purchasing bonds directly can cost you markedly more than what institutions pay, plus you will not be able to assess their credit quality on your own. A professional bond manager (or bond mutual fund for smaller portfolios) may be able to find diamonds in the rough — specific bond issues that are bargains at today’s prices. For most investors, however, it’s best to use mutual funds or a money manager.
Attractive investments exist overseas. Developing nations are expected to grow faster — providing investment returns that exceed US returns on average for years to come (albeit with more year-to-year volatility).
Careful: Changes in currency rates can increase the return from foreign investments if the dollar falls in value in the future, or reduce the return if the dollar rises in value.
Bonds: For income, bonds of “emerging market” nations (such as Brazil, Mexico, Poland, Turkey, and South Africa) may pay higher interest than US bonds with similar investment ratings. These bonds can also provide capital gains opportunities by becoming more desirable as their issuing nations mature.
Best: Buy such bonds through a tax-favored retirement account to protect interest income from tax. A mutual fund is a way to do this cost effectively.
Stocks: Only 42% of the world’s stock market capitalization is now in the US, and foreign stocks have become a standard portfolio component of US investors. Foreign stock mutual funds can help you diversify away from US stock market risk and give you greater access to more foreign companies. Buy them through taxable accounts for tax-favored capital gains.
Barclay’s Bank, a major world bank, issues the notes, the value of which is tied to commodities market indexes or the price of oil. You can buy and sell them just as you would other securities.
Tax advantage: It’s expected that ETNs will trade under tax-favored capital gains rules (though the IRS has not ruled on them yet). Other means of investing in commodities, such as futures contracts, produce income taxed at ordinary rates.
If you will need cash in the coming year and fear a market fall, raise the cash now. With the top capital gains tax rate at an historic low 15%, there has never been a better time to do so.
Prepaying your home mortgage is likely to provide only modest interest savings while reducing your financial flexibility — because it eliminates a valuable source of tax-deductible financing.
Example: The balance on your home mortgage originally was scheduled to be $250,000 today, but you’ve made prepayments totaling $175,000, so your balance is only $75,000.
Benefit: You’ve put away $175,000 through the prepayments, and so have increased your net worth by that much.
Snag: That wealth is not readily available to you — it is locked up in your home, and if you need it in cash, you can borrow only $100,000 against the home while deducting the interest. Interest on home-equity loan amounts above $100,000 is not deductible.
Alternative: Instead of using the $175,000 of savings to pay down your mortgage, place it in another investment, such as a high-quality bond fund.
The savings increases your net worth just as it would if used to prepay your mortgage — but now you also have $175,000 of funds readily available as cash in an emergency, plus you can take out another $100,000 of home-equity borrowing ($275,000 total) if needed.
Moreover, the interest that you earn from the bond fund may equal or even exceed the after-tax interest you pay on the mortgage.
