Individual Retirement Accounts (IRA) and Keogh plans permit setting aside a portion of income and deferring taxes on the cash set aside plus all income from the funds until withdrawn at retirement.
Keogh Plans and IRAs permit setting aside up to 15 percent of gross income, but the upper limit on Keogh (which is designed for the self-employed worker) is The rules for eligibility, penalties, and operations are generally well known.
Not so well known are investment opportunities for these set-aside funds. Generally, four classifications of investments are permitted: insurance plans, special mutual fund plans, trusts offered by savings institutions and banks, and US Retirement Bonds.
A few banks and brokerages offer a self-directed trustee plan, usually with a minimum $10,000 capital.
Under self-directed plans, you may direct the trustee to buy or sell securities, and the risks are yours. The trustee keeps records, controls the certificates, and reports annually on your IRA or Keogh Plan. Each trustee sets limits on investments, and many will not accept options, commodities, precious metals, leveraged real estate, or various kinds of limited partnerships, such as participants in real estate partnerships or oil-drilling ventures.
If you were to move your IRA or Keogh Plan to a self-directed trust, what would you invest in? Since interest and dividends are not taxed until withdrawn , you have more flexibility to compound growth with high-yield securities. Two opportunities are deep-discount bonds (bonds purchased at less than the face value) and income stocks, primarily utilities. If you were to buy deep-discount bonds, you could expect a return of 10 to 12 percent plus a long-term capital gain if you hold the bonds for a year, if interest rates decline and if prices of the bonds rise. Total yield could reach 14-16 percent, counting the expected capital gain from selling at a higher price.
A reader raises the question: "Why not own deep-discount bonds or income stocks outside a Keogh or IRA and take advantage of the exclusion of 60 percent of the long-term capital gain when figuring income taxes?" An example will clarify the trade off:
Outside a Keogh of IRA, taxes depend on your marginal tax bracket. Assume a 40 percent tax bracket, two years holding deep-discount bonds, 12 percent current yield, and 4 percent annual, long-term gain. Taxes each year will amount to $48 on the $120 income from a $1,000 purchase of bonds. After two years the increase in price yields $80 ($40 return for each of two years), and after exempting 60 percent of the gain and paying 40 percent on the remainder, the tax amounts to $12.80. Total tax for two years amounts to $108.80.
Within a deferred Keogh or IRA all of the income is taxed as ordinary income. Assuming the deep-discount bonds are sold after two years and the cash reinvested, the money you made is carried to retirement when the marginal tax rate drops to 25 percent.Total income to be taxed amounts to $320, and at the 25 percent rate, tax totals $80 -- well under the $108.80 noted above.
A different situation exists when holding assets that produce no current income. Putting gold coins or silver bullion into a Keogh or IRA, for example, could be undesirable because your only chance for income is to sell the metals for more than you paid. If you hold gold or silver for longer than a year, you would ordinarily pay taxes on 40 percent of the capital gain, if any. But, within a Keogh or IRA, all of the gain would be taxed at ordinary income rates when withdrawn.