Limiting tax liability not best way to invest

It’s really important that we establish proper goals when structuring an investment plan. Too often, I hear people say that their primary goal is, ‘To pay as little in taxes as possible.’

Be very careful when you set your goals! When you invest, your goal can be to produce as much profit as possible, to be as safe as possible, to generate as much income as possible or to limit your fees or taxes. Your goal will determine your strategy. But often, one goal conflicts with another. For example, if you want your money to be as safe as possible, you wouldn’t also be able to be as profitable as possible.

So when a client says he wants to keep his taxes as low as possible, he is creating limitations. If tax avoidance is the primary goal, an investor may sacrifice other benefits like profit, safety and future security. Thus, while one can achieve the goal of avoiding taxes, I’m afraid that 20 years from now, the investor will be very unhappy when he or she finds that they’ve achieved that goal.

To guarantee low taxes, buy tax-free municipal bonds, or mutual funds that buy municipal bonds. If this is done, the interest income will indeed be tax-free. Congratulations, the goal has been achieved ‘ but only earning about 4 percent annually. That’s a low return ‘ so low that the income will be eroded by inflation. Maybe 4 percent per year produces enough income now, but in five or ten years, that income will be eroded by the increased cost of living. We see this happen all the time: People are fine financially when they retire at age 55, 60 or 65, but when they reach 70, 75 or 80, they find themselves in trouble because their income has not kept pace with inflation.

Risk is another problem. People assume that municipal bonds are safe, because they are issued by state governments ‘ and government bonds are thought to be a lot safer than the stock market. But they’re not really as safe as they seem, because bonds are subject to ‘interest-rate risk.’

Interest-rate risk means that as interest rates change, so does the value of your bond. Here’s how it works: If interest rates go down, the value of the bond goes up ‘ and vice versa. Bond interest and value are on opposite ends of the seesaw.

This is why we take a different approach when we manage money for our clients. It’s better to seek higher returns, even if taxable. Sure, no one enjoys paying taxes, but the trade-off is acceptable. Thus, rather than emphasizing the avoidance of taxes as a primary criterion, make that secondary. Higher priorities should be generating growth or income, or emphasizing safety.

We do this by investing in a highly diversified way. Such a portfolio ‘ over longer periods of time ‘ is able to generate better returns than muni bonds are likely to provide. It’s a much more effective way to invest.

Retirees who hate to pay income taxes often buy municipal bonds. But many are shocked when they discover that their municipal bonds often generate tax liability.

The reason: Social Security.

Single retirees with a combined income of $25,000 to $34,000 must pay federal income tax on half of their Social Security income. If the income is over $34,000, 85 percent of your Social Security benefits will be taxed.

It’s even worse for those who are married and filing jointly: Half of the Social Security income is taxed with a combined income of $32,000 to $44,000, and 85 percent is taxed if it exceeds $44,000.

‘Combined income’ is the adjusted gross income plus half of Social Security income plus all nontaxable interest income ‘ including interest from municipal bonds.

Which means that the munis purchased to avoid taxes on interest income can incur taxes on your Social Security checks. Ironic, huh?

And that’s not all. Income from certain kinds of muni bonds is calculated in assessments of the Alternative Minimum Tax.

I’ve said it many times: Never choose investments because of taxes. If you own muni bonds or muni bond funds, contact your adviser so that he can show you how to fix that dilemma.

Financial Adviser Ric Edelman is the author of several best-selling books about personal finance, including ‘Ordinary People, Extraordinary Wealth’ and ‘Discover the Wealth Within You.’ You can e-mail him at [email protected].