Scared off from investing by the mutual-fund scandals? You can reap the tax advantages of mutual funds by investing in other tax-advantaged vehicles. Here are your best five options, plus an explanation of their tax benefits:
1. Buy individual stocks. This is the simplest route. You won't have any problems with late trading or market timing if you buy shares of IBM, Pfizer, Wal-Mart, etc. Pick at least 10 different stocks from different industries to create diversification.
As long as you simply hold onto your shares, you won't incur taxable gains. If you collect dividends or take long-term gains, you'll owe only 15 percent in tax (5 percent in a low bracket). Moreover, you can pull tax-free cash from your portfolio via margin loans, which may be an attractive strategy while interest rates are low.
2. Wrap it up. You might not want to pick your own stocks. Not to worry: Your friendly broker can put you into a "wrap" account, also known as a managed account or separate account.
In essence, your broker will find one or more money managers to pick stocks for you. You might have a large-cap manager, small-cap manager, international manager, and so on. You'll pay a
On the tax side, participating money managers can customize trading to take your personal situations into account. They can take tax losses, let winners ride, or decide not to sell stocks until they qualify for long-term capital gains.
3. Invest in ETFs. Exchange-traded funds (ETFs) hold a basket of stocks, as mutual funds do, but they trade like individual stocks. They track an index such as the S&P 500, and they are listed under such names as iShares and SPDRs ("spiders").
Because ETFs trade actively, their prices are updated regularly. So ETFs aren't prone to the machinations that have discredited some mutual funds.
ETFs are index funds, so they don't buy and sell their holdings very often. Thus, they seldom generate taxable capital gains. And ETFs are allowed to use certain techniques that further reduce the chances that you'll have to pay tax on capital gains distributions. (For more on ETFs, see box on page 2.)
4. Consider variable annuities. Vari-able annuities offer investment choices that resemble mutual funds. But annuities aren't liquid, so they are unlikely to offer opportunities for in-and-out trading.
Although the fees charged by variable annuities are higher than those of mutual funds, they offer superior tax benefits. Inside a variable annuity contract, you can switch among funds ("subaccounts") tax free, which you can't do with mutual funds that you own outright. You won't owe any tax until you take money out of the variable annuity contract.
On the downside, all profits withdrawn from a variable annuity are taxed at ordinary income rates, so you lose the benefit of low-taxed capital gains. And you'll owe a 10 percent penalty on withdrawals before age 59 1/2.
As a result, variable annuities work best as long-term holdings. So you shouldn't take withdrawals for many years. Don't pull out cash until you're past 59 1/2 and have reached the stage in your life where the benefit of tax deferral exceeds the drawback of paying higher tax rates on capital gains.
5. Tap into variable life insurance. As with variable annuities, variable life insurance allows you to invest in mutual fund "look-alikes," yet have structural illiquidity to protect you against unfair trading practices. Again, you can switch among subaccounts and enjoy a tax-free investment buildup.
But the tax advantages of variable life policies are even greater. You can take a certain amount of policy withdrawals and loans tax free, so you essentially can enjoy untaxed investment income. Moreover, your beneficiary eventually can receive a tax-free death benefit.
What's the catch? You can't completely draw down a variable life policy. If you do, you may owe a bundle in deferred taxes. You can take some cash for yourself but you need to leave some for your beneficiary. If you have a need for life insurance and you expect to keep the policy in place over the long term, variable life can be a good choice.
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