Income Taxes: Legally Avoid the Taxman With Municipal Bonds

David Fessler
by David Fessler, Energy & Infrastructure Strategist

Income Taxes: Legally Avoid the Taxman With Municipal Bonds

by David Fessler, Advisory Panelist

Friday, May 1, 2009: Issue #988

Paying income taxes, for the most part, is a foregone conclusion. You can lower them, avoid them, and even delay paying them. But eventually you must write the government a check, in an amount determined by the I.R.S. Tax Code.

But a number of citizens aren't happy with just paying less tax. They simply don't want to pay any, and have stashed their fortunes in icy Swiss banks or in tropical Bermuda.

In the past, bank officials in those countries would keep the depositor's name a secret, and banking laws in their countries allowed them to do so.

Those days and practices are gone.

  • With the recent capitulation of IBS, the Swiss banking system - one of the biggest and most infamous holdouts to the I.R.S. - bowed to the demands of the taxman and opened up their books.

  • In fact, the world's tax shelters are growing fewer every year.

  • As accountants and lawyers devise even more, clever ways to hide and shield assets, the I.R.S. quickly closes the holes and shells the safe havens.

But don't give up hope. There is a way for you to build a "bomb" shelter that protects your income and your assets from the fingers of the taxman. You can legally avoid paying income taxes in the good ol' USA with a few simple investments.

The Hottest Income Tax Loopholes

Many individuals who are looking to hide assets from the I.R.S. don't have to turn to offshore investing to do it. They can stay right here in the USA, where a number of alternatives present themselves in the form of dummy or blind corporations.

And combined with a much more insidious form of secrecy - that in which bank officials or other authorities simply don't ask for names. It makes for a very appealing climate for the unscrupulous.

There are a few states at the top of the list:

  • Wyoming and Delaware offer fast incorporation services, and limited financial reporting and disclosure requirements.

  • Nevada goes even further: it doesn't ask for the names of company officers or shareholders, and it doesn't share what little information it has with the I.R.S. The reality is that you'll need more information to obtain your driver's license than you'll need to create a corporation in Nevada.

  • As a result, Nevada incorporates around 80,000 new companies a year, and there are currently over 400,000 active companies registered there. There's no question there's bad guys using these states for purposes of money laundering and tax evasion.

No one knows for sure how much money is being sheltered, but none of it has gone unnoticed by the feds. A study conducted by the I.R.S. determined that as many as 90% of the individuals registering companies in Nevada were in violation of federal tax laws.

State Anonymity to Income Taxes Better Than Offshore Havens

In 2005, the Federal government determined that the anonymity offered by Wyoming, Nevada and Delaware was equal to - and in some cases better than - any offshore financial haven. But in the eloquent words of Emerson, "Things refused to be mismanaged for very long."

It now appears as though the U.S., under pressure from its G20 friends, is making a token effort to close the few remaining loopholes, forcing all states to disclose the "beneficial owners" of corporations.

While for now, investing here offers some of the best tax shelters available anywhere, the long arm of the I.R.S will eventually crack down on these loopholes. It's not a question of if - it's a question of when.

So where should investors be looking?

We would never recommend any investment that has dubious legal or tax ramifications, so if we're not suggesting incorporating - what are we talking about? The answer is simple really... municipal bonds.

Avoid Paying Income Taxes With Municipal Bonds

A perfectly legitimate way to invest money and completely avoid paying income taxes on your gains is through municipal bonds and municipal bond funds.

  • Municipal bonds offer exemption from both federal and state income taxes.

  • In some rare cases local income taxes if you live in the taxing municipality that issued the bond.

  • It results in tax-free income - the only way to avoid taxes on your investments.

I know, I know, many of you will be howling at me that you already knew about "munis," as they're known. But let me ask you how many municipal bonds do you own, and when was the last time you checked out the interest rates they offer?

You might be surprised to see returns of over 7% for specific funds and bonds.

A great place to start is municipalbond.com. Here you can learn about municipal bonds in general, and the ones available for sale in your state. If you're interested in checking out municipal bond funds, Morningstar has a great fund screener that you can use to sort munis. You can find it at Morningstar.com.

Municipal bonds are used by states and cities to build bridges, infrastructure and a number of other projects. Many times they are used like bridge loans until tax receipts come due. Regardless of what they do, they provide you with investable opportunities.

Like any investment, it pays to do your research. Munis are no different. It never hurts to talk to a professional about what is appropriate for your situation. What works for California investors doesn't always work for New York investors. One size doesn't fit all here.

Another thing to note on municipal bonds, diversification is just as important here as it is for the rest of your portfolio. In rare cases, some municipalities have defaulted on debt. It's uncommon, but definitely something to think about.

Otherwise, municipal bonds and bond funds are excellent additions to a well-rounded, diversified portfolio. And under our Asset Allocation Portfolio, we recommend 10% in high-grade bonds.

So unless you relish the idea of an I.R.S. inquisition, shady dummy corporations and skirting the law, it's probably best to stick to municipal bonds to legally avoid taxes. They represent a safe and legal alternative.

Good investing,

David Fessler

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