Taxes Don’t Matter… Until They Do

Since the latter part of 2008, the yield on cash has been so low that sheltering it from taxes didn't seem to matter. But if—as we expect—high rates of price inflation are waiting in the not-too-distant future, then sheltering interest income will be very important.

There may be lag time, but interest rates generally track the rate of inflation. So if inflation returns to a 1970s-like 14%, a one-year CD might yield near 15%. Don't get too excited. The real, after-inflation return would still be in the 1% neighborhood, but you would be taxed on the full 15%. So much for your windfall! No one wants to pay taxes on a real yield of 14%, let alone 14% in phantom income. In this high-inflation world, enjoying the safety and readiness of a cash reserve would be painfully expensive. Unless, of course, you could shelter your interest income from taxes.

Interest rates and inflation won't also move in lock step. It's quite possible that interest rates could be 18% while the inflation rate is only 14%. Furthermore, capital markets react to inflation before it filters into consumer prices. There's a small lag between the two, as bond prices include expectations of inflation rather than historical inflation. Nonetheless, if the spread between inflation and interest rates gets very narrow, investors should take a few steps to optimize their yield holdings.

Retirement Plans

The simplest, most cost-efficient way to shelter interest income is through an IRA, 401(k), or other tax-favored retirement plan. There is no hurry, but when inflation and interest rates start moving up, it's time to funnel spare cash in to your retirement portfolio.

Of course, even if you are very wealthy, there are limits on how much you can contribute to an IRA, 401(k), or one of their cousins. In the case of a traditional IRA, if it isn't as big as you would like (compared to the total value of all your investments), there is a way to increase its size by it effectively absorbing assets you already own. You can learn how to do just that in our Yield Book special report.

If IRAs or other retirement plans don't have enough room for nearly all your cash and near-cash assets, the alternative – a second choice, but in some cases a good choice – is to use a deferred annuity. Besides protecting money from inflation, deferred annuities can be used to invest in foreign currencies and diversify away from a rapidly depreciating dollar.

Deferred Annuities

In a deferred annuity, your income is shielded from taxes until maturity, much like it is in a 401(k). The annuity's returns are only taxed upon withdrawal.

Though an annuity presents some tax advantages, it's something to buy only after you've weighed all the features. First of all, the annuity is a deal between you and an insurance company. It is not traded on the open market. In the securities market, you almost always get a fair price for any investment instrument, as market watchers will bid up the price of any underpriced asset and will short an overvalued asset. However, with an annuity, it's impossible to tell how the market might value the deal. The burden is on you to figure out the value. You need to shop.