Randy Williams at Tripod.com told me to write about what I would do if I got a whole bunch of tax-free money - then he qualified his statement. The amount is $100,000 and he wants to know how keep it and grow it with the least tax effect. Well, that squashes my fantasies!

I'll bet that if someone gave you $100,000, the first thing you would do is pay off all your debts. Then you would either buy a house or reduce your mortgage.

Let's explore these first impulses from a tax viewpoint. (Now remember, this may have nothing to do with your debt-comfort level or stress - this is just wealth-building.)

Paying off all your bills:

a) You have outstanding debt on credit cards, at 18% or so - PAY THEM OFF! Unless the credit card debts are for business, you get no tax benefit from paying these outrageous interest rates. But, if you are lucky enough to have a fixed rate card for under 10%, then read on!

b) You have a car loan at under 10% - I'd read Ken Kurson's companion article about how to invest and earn much more than 10% - and I wouldn=t pay off the car loan. (Remember, unless you're self-employed, you canNOT deduct the interest, even if you use your car 100% for your job.)

c) Your mortgage is at 8% - 10% - see my comments on (b) above. In addition to paying low interest, you can fully deduct the interest you pay. That=s still a viable tax benefit.

For our purposes, let's say that you used $10,000 to pay off bills. That leaves us with $90,000

Moving on...next step - if you don't already own a home - buy one. No matter where you are in the USofA $90,000 or $100,000 will go a long way toward buying a house. In some areas, it will even pay for it in full.

Let's say you use all the money to buy a house and have no mortgage, you will have no tax benefits (no interest deduction). However, you will also not have rent or mortgage payments - all you'll have to cover will be property taxes and insurance. So, while you have no interest to deduct, you can save the difference between your old rent/mortgage and your monthly tax/insurance budget. Most likely, that's about $6,000 or more per year that you can invest.

On the other hand, if $90,000 is not enough to buy the house of your dreams, use a portion of it for the down payment - preferably not more than a 20% down payment (with a $250,000 purchase price, that would still leave about $35,000 in your pocket for other financial strategies)

We still have money left over. Now what?

If you've got a job, invest as much as you can into the company's 401k or other pension plan. Generally, you may put as much as $9500 ($6,000 into a SIMPLE) taken from your paycheck before taxes. This means it really only costs you about $6,800 to put away $9,500.

If your employer does not have a retirement plan, you'll have to set up your own IRA (you're married, set up two) and put away $2,000 ($4,000 for couples).

As an employee without retirement coverage, you have three kinds of IRA's to choose from - they all have the same $2,000 limits - and you may only select one:

a) Regular, deductible IRA (tax savings in 28% bracket of $560 or $1,120 for a couple).

b) Regular, non-deductible IRA - no tax savings for the contribution, but earnings grow tax free.

c) Newer, more fabulous ARoth IRA,@ effective as of 1/1/98. You put away $2,000 per person after tax, hold the investment for at least five years, then pay no tax on the earnings - as long as you spend the money on your first home purchase or leave it until you reach age 59 2.

Oh yes, one more IRA - the college IRA. It lets you put a whopping $500 per year away toward the future education of a child (doesn=t have to be your child...). But this one is complicated. The earnings are not taxable if the entire amount is used for allowed educational expenses. However, if the designated child goes to a cheap school - or decides to get a car instead, some or all of the interest could become taxable. There are some tricks to this, and we'll have a few years to figure them out.

And there's still more money to deal with. You didn't realize $100,000 was that much money!

Many people jump right into tax-free municipal bonds so they never have to worry about paying taxes on their earnings. This is great - if you're eighty and frail. If you happen to be hale and hearty, take a risk - try practically anything else. Although the income from these bonds isn't taxable (up to about $100,000), there isn't much income not to tax. The typical rate of return is about 6% - 6.5%, if you're lucky. After tax savings in a 28%bracket, it amounts to no more than 9% return. You can do better than 15% in many mutual funds.

In fact, if you find a fund manager who doesn't churn the fund, your money will grow mostly tax-free until you redeem your shares. Why? Whenever the fund sells off any of their stock at a profit, you - the investor - pay capital gains taxes on those profits. On the other hand, a fund with a low turnover rate can have the same growth rate as one that churns the assets, but cost you substantially less in taxes. The low-turnover fund gets its growth by buying stocks in companies that are strong and growing. These managers hold the stocks for the long term. Therefore, the fund value increases as the values of the stocks increase - without having to sell the stocks to achieve the same results. Most of the publications, Worth. Money, Kiplingers, etc. list the funds and show the turnover rates.

In fact, there was a US News and World Report article on June 9, 1997 that listed the top three picks of 10 successful fund managers. Of the 29 funds (one was selected by two managers). 10 of them had turnover rates of 25% or less. (This means that they did not sell about 3/4 of their portfolio every year.) Looking at the 9 low-turnover funds that had been around for 5 years, their average annual rate of return (over 5 years) was over 27%. Some of them substantially higher than 27%!

Considering a 28% tax rate, you still have over 20% return after taxes. This certainly beats the 6.5% tax-free returns. But most of this will be capital gains, so the after-tax returns will be even higher - and much deferred. The only thing you pay taxes on while you hold the funds, are your share of the dividends - which you leave to be reinvested and grow.

Let's be truthful, though. These returns are based on a booming market. If you prefer security, go for the bonds.

Any other tax-advantaged things you can do with your money?

Take the whole batch of leftover money ( about $30,000 at this point) and buy yourself an annuity. It will grow tax-free at about 7% - 9%. Some of them may let you borrow against it after 7 years or so. Some annuities will also let you chose to invest part of the money within the annuity in stock-based assets. These add marginally to the risk, because most of these annuities seem to provide a minimum guaranteed rate of return.

Personally, being self-employed, I'd look at a non-tax-advantaged investment - disability policy that would replace at least 75% of my income. While you get no tax benefits for the premiums you pay, you get real benefits if you are ever unable to work. AND the disability income you receive is not taxable because you paid for the premiums. (The premiums are not deductible as medical or business expenses.)

There are probably a few more options, but your eyes are probably glazing over by now.

What would I do with a free $100,000? Heck, I'd pay off all my bills, except the mortgage. Then I'd spread the rest among several of those 9 low-turnover funds. Some of the money I'd free up from bill-paying would go into my retirement accounts - which would also be invested in those funds.

The rest of the money - well, I'd go play, of course. Wouldn't you?

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Sites to play with:

WSJ.com's site  

Worth Magazine 

Kiplinger Online 

Kiplinger Calculators and Tools 

U.S. News and World Report Online

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Copyright © Eva Rosenberg, October 24, 1997