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Taking the Sting Out of Taxes

When Ross Perot ran for president in 1992, the Texas billionaire revealed his simple investing strategy: He had put nearly everything into municipal bonds. The approach violated textbook advice that urges investors to hold diversified portfolios. But for wealthy investors, the rules may be different. We see high-net-worth investors that have 100 percent of their accounts in equities or 100 percent

When Ross Perot ran for president in 1992, the Texas billionaire revealed his simple investing strategy: He had put nearly everything into municipal bonds. The approach violated textbook advice that urges investors to hold diversified portfolios. But for wealthy investors, the rules may be different. “We see high-net-worth investors that have 100 percent of their accounts in equities or 100 percent in bonds, and either approach can be valid for them,” says Fran Kinniry, a principal of Vanguard Group.

Clients with millions of dollars may prefer holding bonds and see little reason to bother with the extra risk of stocks. And, in those rare cases, who could argue? On the other hand, some wealthy clients — clients who wish to leave assets for children and grandchildren — may need to take an aggressive position in stocks. Assets earmarked for future generations have the benefit of time: The time horizon for such a portfolio could be 60 years. The proper allocation, then, might be to put 80 percent or more of assets into stocks.

For high-net-worth investors, tax-sheltered accounts offer special opportunities. Because they need not worry about exhausting savings, wealthy clients can use shelters creatively to derive maximum tax and investing benefits.

Consider Health Savings Accounts, which were introduced to help people pay for medical bills. Under the program, a participant can put up to $5,250 a year into one of the tax-sheltered accounts. The plans offer a variety of investment choices, including stock and bond mutual funds. Most participants keep the cash in money market funds and write checks from the accounts to cover expenses. But investors who already have a few million dollars need not take the usual approach. According to the rules, if you don't spend the money, it can sit in the health tax shelter indefinitely. Wealthy people may decide to keep their cash in the tax-deferred account and pay for medical expenses out of their pockets. High-net-worth investors can view the health plans as basic elements in their overall portfolios. An aggressive investor may decide to put most of his health plan into equities, while conservatives may stick with bonds.

When they turn 65, participants can withdraw the cash left in the accounts and spend it on anything — without paying any taxes. “For people who can afford it, the health accounts are nice savings vehicles,” says Eric Remjeske, a partner with Devenir, a registered investment advisor in Minneapolis.

Let It Run

Like health accounts, IRAs and other retirement accounts offer wealthy people room to maneuver. The traditional advice for retirement savers is to start with a big stake in stocks and gradually shift to fixed income as the individual approaches retirement. But for an elderly person with $10 million, there may be no reason to change allocations over the years. Instead of saving for retirement, the wealthy investor may really be managing an endowment; most of the cash will be earmarked for charity or heirs.

Many endowments have traditionally put about 60 percent of assets in equities and 40 percent in fixed income. That allocation generates income to cover expenses and charitable gifts, as well as producing growth to maintain the portfolio. The traditional endowment formula might serve a wealthy person for decades. At 40, the wealthy saver would have 60 percent of assets in stocks, and he would hold the same allocation at 70.

Regardless of the portfolio's allocation, you should use the IRA to maximize tax benefits. The aim is to put the holdings that generate the biggest tax bills into the IRA, while leaving tax-efficient assets in taxable accounts. Suppose the investor wants to keep 60 percent in equities and 40 percent in bonds. He has $5 million in mutual funds, including $1 million in an IRA. According to research at Vanguard, the tax-smart investor should fill the IRA completely with corporate bond funds. Vanguard's reasoning is that interest payments from bonds are considered ordinary income and taxed at a maximum rate of 35 percent. Such bonds generate big bills in taxable accounts.

Some advisors take a different approach, arguing that IRAs should shelter a portfolio's most volatile stock funds, such as small growth or emerging markets. Because they tend to bounce up and down, the aggressive choices often become overweighted in the portfolio and must be sold for rebalancing. That generates short-term capital gains, which are taxed as ordinary income.

Whether they emphasize stocks or bonds, investors should hold some cash in their IRAs as they approach retirement, says Lewis Altfest, president of L.J. Altfest, a registered investment advisor in New York City. When investors turn 70 1/2, they must start to take mandatory taxable withdrawals from IRAs. “It's better to pull out cash instead of taking the risk that you may be forced to finance withdrawals by selling stocks during a downturn,” says Altfest.

Besides sheltering investors from income taxes, 529 college savings plans can provide protection against estate taxes. A married couple can invest up to $100,000 immediately into one of the accounts. The money is removed from the parents' taxable estate.

The traditional investment advice for college savings is to start out aggressively, setting aside a stock-heavy portfolio for an infant. As the child hits 10 or so, the time horizon to college shrinks and the portfolio should begin shifting to fixed income. By the time the 18-year old reaches campus, the portfolio should be mostly in fixed income. But here again, high-net-worth people need not follow the traditional advice. Aggressive investors may choose to emphasize stocks, knowing that even if markets turn down, the parents can still pay the bills.

People who have made maximum investments in retirement plans and college savings plans may turn to variable annuities for additional tax shelter. Annuities introduced in the last several years have particular appeal for conservative investors who are wary about the stock market. While annuities come with extra fees, the costs may be worthwhile for clients who crave security. In some contracts, you can invest in a stock fund. After a certain period, you can then choose whether to take the market results or accept a minimum annual return of 5 percent or so. “Because of the extra protection, a client who once had 40 percent of his portfolio in equities may feel comfortable raising that to 50 percent or 60 percent,” says David Longfritz, senior vice president of John Hancock Annuities.

For high-net-worth clients who have big investments in private equity or aggressive stocks, an annuity can provide diversification. A variable annuity with an income guarantee won't necessarily track stocks. Instead, annuities can be seen as unusual hybrids, providing some of the security of bonds along with the upside potential of equities.

Extra Punch for Retirement Accounts

Even after they've retired, many high-net-worth clients have reason to invest aggressively. These large-cap winners can pack some punch.

Name Ticker 1-Year Return 3-Year Return 5-Year Return % Category 5-Year Return Maximum Front-End Load
Fidelity Contrafund FCNTX 22.4% 15.9% 3.9% 2% 0%
Hancock US Global Leaders A USGLX 9.6 8.4 2.2 5 5.00
Legg Mason Growth LMGTX 16.6 26.2 4.6 1 0
Nations Marsico 21st Century A NMTAX 23.7 20.9 4.1 2 5.75
Smith Barney Aggressive Growth A SHRAX 19.4 17.9 0.0 8 5.00
Source: Morningstar. Returns through 7/31/05.
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