Determine The Effects Of Taxes And Inflation On Your Investment Return

Tax-Sheltered Investments

Some investments provide tax advantages by either eliminating or postponing income tax on the investment income or growth. In what kinds of investments can you place your money to shield yourself from taxes? Here are some you might want to consider:

• Tax-free municipal bonds. Interest earned from these government certificates of debt is usually free from federal income tax. Earnings from the sale of municipal bonds are subject to capital gains taxes.
• Annuity contracts. An annuity is a series of guaranteed lifetime payments usually paid by an insurance company. Earnings from investor contributions to the annuity are immune from income taxes until the annuity is paid. Distributions from annuities prior to age 59½ may be subject to an additional 10 percent penalty tax. Annuity withdrawals will be taxed in the same year they are withdrawn.

Strategies That Defer Or Reduce Taxes

Tax-deferred retirement plans give investors the opportunity to defer taxes on investment earnings until retirement (usually age 59½). Pre-tax earnings can be reinvested, greatly compounding the amount of interest you earn from your investments. Some of the most common types of tax-deferred retirement plans include the following:

• 401(k) plans. These plans give employees the ability to place a portion of their salary (up to $16,500 or 100 percent of their compensation) in 2009 and 2010 into a company-sponsored investment account. Taxes are deferred on earnings from the plan until they are withdrawn. In addition, contributions to the plan are deducted from your ordinary income. Employees are given several options for investing the money into their 401(k)s. Most 401(k) plans have matching employer contributions.

Hedging Against Inflation

Inflation can be a serious problem for investors, especially in countries that routinely experience double-digit inflation. Some investors try to minimize the risk of inflation by using hedges. Hedging is the practice of investing in assets for the purpose of reducing or eliminating particular sources of risk in a portfolio.

Suppose you are planning to retire and will receive a pension that pays you a fixed amount of money every month. If we experience high inflation, your monthly purchasing power will deteriorate. You might want to hedge against the risk of inflation by purchasing an asset whose returns are linked to the rate of inflation. Annuities or bonds whose returns are linked to the Consumer Price Index (CPI) will provide you with returns that increase when inflation increases. These types of assets are considered perfect hedges against inflation.