Reducing Your Tax Liability

A strong savings program is essential for any sound financial strategy.

We take Benjamin Franklin’s saying to heart, "A penny saved is a penny earned", and we lay away our spare cash in savings accounts and certificates of deposit. Those investors who’ve accumulated an adequate cash reserve are to be commended. But as strange as it sounds, it is possible to save too much, or rather, to save what we should be investing. That may not sound like much of a problem — but it can be. You see, many investors simply put their savings into the most convenient and secure financial instrument they can find. As often as not, that turns out to be certificates of deposit.

Certificates of deposit are FDIC insured and offer a fixed rate of return, whereas both the principal and yield of an investment in securities will fluctuate with changes in market conditions. When liquidated, the investor may receive back more or less than the original investment amount. Unfortunately, placing all your savings in taxable instruments like certificates of deposit can create quite an income tax bill. In an effort to ensure security, some investors inadvertently produce a liability. It’s a bit like turning on all the taps in your house just to make certain the water’s still running. Sure, you’ll know that the water’s still running, but a lot of it will go down the drain. The solution is simply to turn off some of the taps.

Deferring or eliminating income tax

There are a number of very secure financial instruments that will enable you to defer or eliminate income taxes. By shifting part of your cash reserves to some of these instruments, you can keep more of your money working for you — and turn off the taps that hamper your money’s growth.

Some tax strategies to consider

One possibility you may want to consider is a fixed-annuity contract.

Fixed annuities are a unique alternative that can help you meet the challenges of tax planning, retirement planning, and investment planning. Fixed-annuity contracts accumulate interest at a competitive rate. And the interest on an annuity contract is usually not taxable until it is withdrawn. Most annuities have surrender charges. These charges are assessed in the early years of the policy if the policy owner surrenders the annuity before the insurance company has had the opportunity to recover the cost of issuing the policy. Also, withdrawals made from an annuity prior to age 59½ may be subject to a 10 percent penalty.

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Another possible tax-advantaged investment is municipal bonds, which are one of the most popular tax-exempt investments available. They are issued by state and local governments and are generally free of federal income taxes. In addition, they may be free of state and local taxes where they are issued.

Municipal bonds can be purchased individually, through a mutual fund, or as part of a unit investment trust.

Income from municipal bonds and municipal bond funds may be subject to federal, state, or local alternative minimum tax. Also, if you sell a municipal bond or shares in a municipal bond fund at a profit, there are capital gains to consider.

There are a number of other tax-advantaged investments you can consider. If your savings portfolio is generating a tax liability, you may want to consider the alternatives offered by tax-advantaged investments.