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Financial Planning / Tax Strategies


Subject:  Re: Investment/Tax Strategy Date:  5/27/1997  12:47 PM
Author:  TMFTaxes Number:  26 of 128041

On Fri, 23 May 97 17:12:24 -0600, ORWAHOO wrote:

I want to thank TMF Taxes and the folks at Motley Fool for this invaluable service.

Now for my question: This is one of those questions that is also related to Investment strategies, but I need to understand the tax angle.

First, background on me: I'm a 29 year-old Foolish investor. I manage my own IRA and a decent-size (for a 29 year-old) non-IRA portfolio. I'm fully invested in stocks and hold for the long term. I'm investment 'savvy,' but not necessarily tax 'savvy.' But, like many Fools, my investment knowledge is focused on individual stocks, and not mutual funds or bonds.

My father, in seeing my knowledge about the stock market (he has NO experience in investing), asked me to invest $100,000 for him. He's still a decade away from retirement, and, as a successful attorney, does not have immediate need for the money. Needless to say, he's in the highest tax bracket.

I plan on investing over a period of time (dollar cost averaging). I'll immediately put 20% into BTD stocks and perhaps short 10-20%. Then, every month or two, I'll buy a block of stock worth about $7,000. Over a 12-24 month period, I plan on eventually fully investing him in stocks.

(Tax question alert)

In the meanwhile, he will have a substantial amount of cash on hand. Should we keep this in a broker's money market account? Or, for tax purposes, should he have the cash in a tax-free bond fund, while periodically withdrawing money to invest in stocks? But, by periodically withdrawing from the bond fund, is he 'selling shares,' and therefore opening himself up to short-term capital gains?

I obviously want to maximize his return, and will likely (hopefully) have some short-term capital gains from successful shorts. I appreciate your thoughts on this.>>

Not knowing Dad's individual tax situation, it is difficult to provide you with an exact answer. But we can certainly kick around a few ideas.

It may certainly make sense to had Dad's cash in a double tax free municipal bond money market account. You'll have to do some computations in order to determine his "after tax" return for the MM fund versus the broker cash fund. For example, lets say that the brokers fund pays 5% interest. Lets also assume that you can find a double tax free MM fund that pays 3% interest. Lets also assume that Dad is in the 40% tax bracket.

The after tax return on the 5% earned from the broker would actually amount to 3%. The other 2% would be eaten up in taxes. (do the math...the after tax return would be 60% of 5%, or 3%). Compare that to the tax free MM fund, and you see that there is no difference. So the decision would be an either/or situation. But in many cases, and with high bracket taxpayers, you may find that the tax free MM account is the better way to go.

You should also be aware that many brokers offer double tax free MM accounts where you can park your free cash. Again, if that is offered, you'll have to do the math and determine the after tax rate of return. Only then can you make a decision.

Finally, in the above explanation, you will not that I have used a MONEY MARKET double tax free fund, and NOT a pure municipal mutual fund. Why? Certainly there may be other gains and losses generated by the fund (that will be taxable to Dad). But more importantly, your cash is generally for short term use. Jumping in and out of a municipal mutual fund could be a problem when looking at principal preservation. You'll have costs, fees, and expenses to pay with each purchase and/or redemption. Plus, any short term fluctiuations in interest rates might severly reduce Dad's principal in the fund. On the other hand, a MONEY MARKET fund allows you to put $1 in, and take $1 out. More like a savings account. The principal is more secure, and not subject to short term fluctuation.

The downside is that a MM fund will pay less in returns than a full blown mutual fund. Is that a problem? Again, you'll have to compare after tax rates of return.

So get your calculator out and do some computations. You'll need to know your Dad's combined Fed and State tax rate, and the return rates on the various investments that you are reviewing. But all of that information should allow you to make your best assessment of the investment landscape, given your timing and need for the funds.

TMF Taxes
Roy Lewis
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