Financial Topics Newsletter Archive
SBT Investment Services, Inc. through its relationship with Infinex Investments, Inc., member SIPC/FINRA, offers a range of educational resources to help customers achieve their life goals. These include the personal attention of our Advisors, registered representatives of Infinex Investments, Inc., periodic educational forums, and topical articles in our Financial Newsletter.
We publish this online newsletter monthly and maintain an archive of past issues. If you have any questions about or would like to discuss an article, please contact one of our Advisors.
August 2007
In This Issue:
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Do You Need Bonds in Your Portfolio?
Why should you consider bonds for your investment portfolio? The primary reasons include:
- Bonds can add diversification to your investment portfolio. One strategy to counter the effects of stock market volatility is to add investments to your portfolio that aren’t highly correlated with movements in the stock market. Historically, stocks have a low positive correlation with corporate and government bonds. (Past performance is no guarantee of future results.) With this strategy, bonds will hopefully increase or not decrease as much when the stock market turns down.
- Many bonds offer fixed, periodic interest income and the return of your principal at a specified future time. Thus, even during a significant bear market, you’ll receive some return in the form of interest payments, and you’ll receive your entire principal at maturity. Bonds also offer capital gains potential. A bond’s price generally rises when interest rates fall and declines when interest rates rise. If you sell a bond before maturity, you may have a gain or loss on the transaction. However, you can avoid the loss by holding the bond to maturity, when you will receive the full principal amount.
- Bonds are often better suited for short- or medium-term financial goals. If you’ll need the money in a few years, you may not want to keep it in stocks and run the risk that a major market decline could significantly reduce your portfolio when you need the money.
- Despite these advantages, you might not feel that bonds are attractive now, since long-term rates are not much higher than short-term rates. For instance, as of July 20, 2007, three-month Treasury bills had a yield of 4.98%, while 10-year Treasury notes had a yield of 5.04%, and 20-year Treasury bonds had a yield of 5.20% (Source: Federal Reserve Statistical Release, July 20, 2007). However, there are strategies you can use in this environment:
- Stay invested in short-term bonds until long-term rates increase. When long-term rates increase, you can shift some of your principal into longer-term bonds to lock in higher rates.
- Ladder your bond portfolio. A bond ladder is a portfolio of similar amounts and types of bonds that mature on several different dates. For instance, a $30,000 portfolio might consist of six issues of $5,000 each, maturing in six consecutive years. Since the bonds mature every year or so, you reinvest the proceeds over a period of time rather than in one lump sum. If rates increase, you have money every year or so to reinvest at the higher rates. With declining rates, you have some funds invested in longer-term bonds.
- Consider corporate bonds. Corporate bonds typically carry more risk than Treasury securities, but returns are also typically higher. While 30-year Treasury bonds currently yield 5.12%, Aaa rated corporate bonds yield 5.74%, and Baa rated corporate bonds yield 6.63% (Source: Federal Reserve Statistical Release, July 20, 2007).
- Evaluate municipal bonds. If you are in a high marginal tax bracket, consider municipal bonds, which currently yield 4.55% (Source: Federal Reserve Statistical Release, July 20, 2007). Since the interest income is generally exempt from federal income taxes, that means the taxable-equivalent yield is 7.00% for a taxpayer in the 35% tax bracket, 6.79% for a taxpayer in the 33% tax bracket, and 6.32% for a taxpayer in the 28% tax bracket. The taxable equivalent yield would be higher if you select a bond issued in your resident state, which would also be exempt from state and local income taxes. The interest income for some investors may be subject to the alternative minimum tax (AMT).
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Tax-Efficient Investing
During periods of uncertain returns, it becomes even more important to consider other ways to increase your portfolio’s value. One of those strategies is to invest in a tax-efficient manner.
Taxes can significantly reduce your portfolio’s value. Dividends and interest income from taxable portfolios and distributions from 401(k) plans and individual retirement accounts are taxed in the year received, at ordinary income tax rates of up to 35%. Taxes are not paid on unrealized capital gains in taxable accounts. When the asset is sold from a taxable account, however, you must pay taxes on those capital gains, at a maximum capital gains tax rate of 15% (5% for individuals in the 10% or 15% tax bracket) for investments held over one year. Capital gains on investments held for one year or less are short-term capital gains and are taxed at ordinary income tax rates.
Using strategies that defer the payment of taxes for as long as possible can make a substantial difference in your portfolio’s ultimate size. Consider the following tax-efficient strategies:
- Minimize portfolio turnover. Carefully evaluate your investment choices, selecting those you’ll be comfortable owning for years. That way, you can let any realized capital gains grow for many years.
- Place investments that generate ordinary income or that you want to trade frequently in your tax-deferred accounts. Since income and realized capital gains inside tax-deferred accounts aren’t taxed until withdrawn, you defer paying taxes on that income. Keep in mind that withdrawals may be subject to a 10% federal penalty if made prior to age 59 1/2.
- Analyze the tax consequences before rebalancing your portfolio. Portfolio rebalancing is a taxable event that may result in a taxable gain or loss. You should generally avoid selling investments for reasons other than poor performance. You can bring your asset allocation back in line through other means. For instance, when adding investments to your portfolio, only purchase those that are underweighted in your portfolio. Reinvest interest, dividends, and capital gains in investments that are underweighted. Any withdrawals can be made from overweighted investments. Or rebalance through your tax-deferred accounts, which typically won’t result in current tax liabilities.
- Utilize losses to offset capital gains. Selling investments at a loss can offset capital gains for that year, reducing your total tax liability. Excess losses may be used to offset up to $3,000 of ordinary income and the unused portion may be carried forward indefinitely. If you still want to own that investment, you can purchase it 30 days before or after selling it. That way, you will not be subject to the wash sale rules, so your loss will be tax deductible.
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Muni Bond Tips
Whether you’re just investigating municipal bonds or are reviewing your current muni bond portfolio, consider the following guidelines:
- Compare the returns from municipal bonds to other types of bonds. Since the interest is generally exempt from federal, and sometimes state and local, income taxes, your marginal tax bracket is a significant factor in deciding whether municipal bonds are appropriate for your situation. (Any capital gains are subject to taxes. Interest income for some investors may be subject to the alternative minimum tax.) Make sure to determine how a muni bond’s yield compares to the after-tax yield on a comparable taxable bond. To do that, calculate the tax-equivalent yield for the municipal bond.
- Don’t simply select the bond maturity that offers the highest return. Since interest rate changes can significantly affect your bond’s market value, it may make more sense to select a maturity that coincides with when you need the principal. If you are investing with a long time horizon, evaluate the yield curve for municipal bonds before deciding on a maturity date. You may find that increasing the maturity of your bond by a couple of years will increase your return or that committing your funds for a long time does not bring much additional return in exchange.
- Look at the bond’s call provisions. Most municipal bonds come with a call provision, which allows the issuer to redeem the bonds prior to their scheduled maturity. Calls are generally only exercised when market interest rates are lower than the interest rate being paid on the bond and are generally not good news for the bondholder. While most municipal bonds have call provisions, the exact provisions can differ significantly among bonds.
- Review the bond’s credit quality. While municipal bond defaults are rare, they do occur, so review carefully the credit quality of muni bonds. You may want to stick with investment-grade ratings, which means that the issuer is considered financially stable and unlikely to default.
- Hold a diversified portfolio. You should plan to hold at least seven to nine different issues to ensure adequate diversification. Be careful not to hold an excessive number of individual issues, which can become an administrative struggle. For each bond owned, you need to ensure that interest payments are received, reinvest the interest income, and monitor credit quality, maturity dates, and call dates.
- Consider bonds issued in your resident state. Purchasing muni bonds issued in the state in which you reside generally means that your interest income will also be exempt from state, and sometimes local, income taxes.
- Search until you find a bond that meets your criteria. With so many different bond issues available, you should be able to find one that meets your particular criteria.
- Review your holdings periodically. Review the credit ratings of all your municipal bonds at least annually to make sure the quality hasn’t deteriorated. Check the call provisions so you aren’t surprised by a call in the coming year. Also, review your holdings to see if they are still consistent with your overall investment objectives and asset allocation plan.
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The Basics of HSAs
Health savings accounts (HSAs) provide a way to help save on medical costs. To qualify, you must be covered by a health insurance policy with a minimum deductible of $1,100 for individuals and $2,200 for families in 2007. Maximum out-of-pocket costs for the plan, including deductibles and copayments, must not exceed $5,500 for individuals and $11,000 for families in 2007. You can then set up an HSA account, where you can deposit pretax dollars up to your deductible every year. In 2007, these amounts are capped at $2,850 for individuals and $5,650 for families. Individuals over age 50 can make a catch-up contribution of $800 in 2007, $900 in 2008, and $1,000 in 2009 or later. Contributions can be made by you, your employer, or a combination of both. There are no income limits for setting up an HSA.
Individual contributions result in an above-the-line deduction on your tax return. Any contributions made by your employer are not taxable to you. Self-employed individuals and employers can deduct contributions as well as insurance premiums. Individuals not covered by an employer’s plan can purchase a qualified medical insurance policy on their own and make tax-deductible contributions. However, premiums are not tax deductible for individuals.
Money in the HSA can be spent tax free on health care expenses, including eye care, dental expenses, prescription and nonprescription drugs, COBRA premiums, and qualified long-term-care services. Unlike flexible spending accounts, you don’t have to use all the money in the current year. Any unused amounts stay in your account and grow tax deferred. Thus, individuals who can afford to pay their deductibles from personal funds can use the HSA as a way to save funds on a tax-deferred basis. If you use the funds before age 65 for other than qualified medical expenses, you must pay income taxes as well as a 10% penalty on the funds. After age 65, the 10% penalty is waived. At all times, the money in the account belongs to you.
After age 65, you can’t make new contributions to an HSA, but you can still use money in the account to pay medical expenses, including premiums for Medicare Part A and B and the employee’s share of medical insurance premiums paid by an employer.
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What Is More Important?
With limited resources for saving, which is the more important financial goal — saving for your retirement or saving for your child’s college education? While many parents want to pay the entire cost of their children’s college educations, the reality is that there are a variety of ways to pay for that education — personal savings, financial aid, and loans. Unfortunately, there aren’t similar options for your retirement. No one is likely to loan you money if you haven’t saved enough for retirement. You may want to maximize your retirement savings, realizing that there are ways to use those savings to help with education costs. How can that strategy help when it comes time to send your child to college?
- Your retirement savings won’t be considered in financial aid formulas. The federal financial aid formula does not consider retirement accounts, including 401(k) plans and individual retirement accounts (IRAs), when calculating your expected family contribution. For other assets, the formula assumes that 5.6% of the parents’ assets and 20% of the student’s assets will be used annually for college costs. Thus, you may actually increase your financial aid award by saving in retirement accounts.
- You can still use these retirement assets to help pay for college costs. Money in IRAs can be withdrawn to pay higher-education expenses before age 59 ? without incurring the 10% federal tax penalty, although income taxes will be assessed on the taxable portion of the distribution. If the money is withdrawn from a Roth IRA, your contributions can be withdrawn at any time without penalty or taxes, while earnings can be withdrawn before age 59 ? by paying income taxes but not the 10% tax penalty. With 401(k) plans, you typically can’t withdraw the money before retirement age unless it is for a hardship withdrawal, but you can borrow funds if permitted by the plan. If you don’t need the money to finance college costs, you can leave it in your retirement plans to continue to grow for your retirement.
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Copyright © 2008. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.
FR2007-0420-0124
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