The
high rate of inflation most of us believe is waiting not too far down the
road will be an earthquake for investment markets. The likely winners (gold,
silver, precious metals stocks) and the likely losers (long-term bonds and
most stocks) aren’t too hard to identify. But separating the sheep from
the goats is only one element for financial success in an environment of
rapidly rising consumer prices.
Higher
rates of price inflation will bring greater volatility to all financial
markets. The higher you expect inflation and hence gold to go, the more
volatility you should expect to see for assets of every type. Even if in fact
the dollar is on the road to perdition, there will be detours and
backtracking along the way.
Inflation
doesn't operate smoothly; it is a disrupter for both the economy and for the
political system. From time to time over the next five to ten years, the
Federal Reserve will come to see inflation as its most urgent problem. And
every time that happens, the Fed will slow the creation of fresh dollars or
even put up a big INTERMISSION sign and stop printing altogether for a while.
Such
seizures of monetary virtue won’t last long, but while they do last,
they will hammer most investment markets, including the market for the yellow
stuff and for stocks of companies that produce or look for it. You could be
absolutely correct about where the dollar is headed in the long run and still
have a scary ride.
2008
was just a preview of the downdrafts you will need to survive. There will be
even uglier smash-ups, and you don’t want to be among the hard-money
investors who get carried off on a stretcher. To avoid being one of them,
you’ll need to include cash as a constant, permanent element of your
portfolio. Cash is a courage booster. Having a substantial cash reserve makes
it easier to hold on to your other investments when they are getting battered
and you are tempted to bail out. And cash gives you the wherewithal to buy on
dips – and on the big dumps.
The Twins
Of
course, cash will be the asset whose value is shrinking. But the rate at
which the purchasing power of your cash declines will depend very much on how
you hold it.
Interest
rates on money market instruments, such as Treasury bills and large CDs,
track the rate of inflation fairly closely. By creating money fast enough,
the Federal Reserve can keep rates on money market instruments one or two
percentage points below the inflation rate, but not indefinitely. And any
such effort to suppress short-term interest rates succeeds at the cost of
producing even higher inflation later. Similarly, the Fed can keep money
market rates one or two points above the inflation rate for a while, with the
likely eventual result of a slowing in inflation. But over long periods, the
average yield on money market instruments about matches the average rate of
inflation.
Given
that money market yields travel the same path as inflation rates, holding
cash doesn’t seem to be terribly painful. The loss in purchasing power
about gets made up for by the yield. That’s a nice thought –
until you think about taxes. Even though the yield is merely replacing the
purchasing power being lost, the yield is subject to income tax, unless you
do something about it.
Doing
nothing about it is, in a subtle way, risky for your portfolio. When price
inflation gets to, say, 10% and money market yields are near the same level,
if you are in a 40% tax bracket, you’ll be losing purchasing power on
your cash at a rate of 4% per year. The situation will get worse as inflation
moves higher, and you’ll be tempted to cut back on cash in order to cut
back on the leakage. And that will leave you dangerously ill-prepared for the
next INTERMISSION sign.
Logically,
then, to make holding cash cheap or even free, you need to hold the cash in
an environment where the yield is protected from taxes. Let’s look at
the possibilities, some of which, you should be warned, may make you say
“Yuk.”
Deferred Annuities
A
straight annuity is a contract with an insurance company that pays you a
certain amount per year for the rest of your life. A deferred annuity begins
with an accumulation period, during which the contract earns interest or some
other investment return. You can end the accumulation period whenever you
want and then either start receiving a lifetime of payments or simply
withdraw the contract's accumulated value.
Earnings
in a deferred annuity are tax-deferred until they are withdrawn. So if the
return on a deferred annuity tracks money market yields, then the real value
of the annuity will hold approximately steady, even at high rates of
inflation.
Deferred
annuities are now an almost forgotten topic. They were, for the first time
ever, a very big topic in the high-inflation years of the 1970s and 1980s.
The reason was simple – sky-high interest rates. But in more recent
experience, interest rates have been so low that the advantage of
tax-deferred compounding has hardly been worth the trouble. It's when
interest rates are high that tax-deferred compounding brings a big payoff.
When
price inflation heats up and puts money market rates on a boil, expect to see
ads for deferred annuities on every financial street corner. The right
annuity contract will certainly be better than leaving cash in a bank
account, but it still won't be the most attractive medium for holding cash
through a period of rapid inflation. There are one, or perhaps two,
limitations on an annuity's appeal.
The
first is that the protection from being taxed on a fictitious return only
goes so far. Even though the money inside the annuity may be holding its
purchasing power (with interest continuously replacing what is being lost to
inflation), eventually you'll cash the annuity in. At that point, all the
interest will be taxable. After, say, a decade of high inflation, most of
what comes out of the annuity will be accumulated interest – which will
be taxable as ordinary income. So you'd have a one-time loss of nearly 40% of
your purchasing power, assuming you're in a 40% tax bracket. (I know that sounds
awful, but it would be a far better result than paying tax on interest income
year by year during a decade of rapid inflation.)
The
second limitation is that, so far as I have been able to determine, no insurance
company offers a program that would let you switch the value of an annuity
between money investments and something related to precious metals. That may
change as inflation and the public's interest in gold picks up. But until it
does, there would be no tax-efficient way to tap the purchasing power your
annuity had been protecting to buy something gold-related during the
downdrafts we're trying to prepare for.
Cash Value Life Insurance
As
with a deferred annuity, the earnings on a cash value life insurance policy
can accumulate and compound free of current tax. But that’s where the
similarity ends.
Unlike
the earnings on a deferred annuity, the earnings on cash value life insurance
can come out of the policy tax free. The tidiest way is for you to die at
just the moment that is most convenient for your financial plan. An
alternative, if you don’t have such an accommodating attitude, is to
borrow the earnings from the policy. You can do so tax free if the policy
satisfies the “7-pay” rule: pay for the
policy no more rapidly than with seven equal annual premiums.
Being
able to borrow from the policy tax free would allow you to tap its value
whenever gold and other hard investments have had a sizeable setback.
Convenient. But, depending on your circumstances, that convenience may or may
not be available to you for free.
Between
the Internal Revenue Code's requirements for a contract to qualify as
“life insurance” and the perversely characterized “consumer
protection” rules of the various states, it is not possible to buy a
life insurance policy in the U.S. that does not have a face value far above
the amount you’ve invested in the policy. The difference represents the
insurance company’s risk – mortality risk – that you may
stop breathing ahead of schedule. The insurance company, of course, will
charge for that risk. There are a lot of variables, but think of the charge
as amounting to something on the order of 1% per year of the capital you want
to wrap inside the policy to protect the return from taxes.
Whether
a cash value insurance policy (a 7-pay policy, so that you can borrow tax
free) is a good place to shelter cash from the winds of inflation depends in
large part on whether paying for mortality risk is or is not a wasted cost
for you. If you now have a reason to own term life insurance, you are paying
purely for mortality risk. In that case, it would make sense for you to
convert to a cash value policy that could be invested in money market
instruments as a way to prepare for high inflation. There wouldn’t be
any additional mortality cost, and you would get the tax advantages of life
insurance.
On
the other hand, if you have no use for pure life insurance coverage, using a
cash value policy for its tax advantages would require you to become a regular
bettor in the actuarial casino, which you probably would not want to do.
Retirement Accounts
If
it is available to you, by far the best way to hold cash through an
inflationary storm is in an Individual Retirement Account. Without any of the
costs that come with a deferred annuity or a life insurance policy, you can
invest in T-bills, insured jumbo CDs and other money market instruments and
in near-cash assets such as very short-term bonds. You can have a free hand
to tap the cash at opportune times to purchase precious metals and precious
metal stocks. The whole arrangement is protected from current taxes, and with
a Roth IRA the proceeds eventually can come out tax free.
You
can do exactly the same with a solo 401(k) plan. And if you have a 401(k)
plan that's sponsored by your employer, you may be able to do about the same,
depending on the investment options the plan allows.
A
retirement plan would be the ideal vehicle, but there is a size constraint.
While the size of a deferred annuity or of a cash value life insurance policy
is limited only by the size of your checkbook, IRAs are not so easily
scalable. However, if you have a traditional IRA and would like to move a
chunk of non-IRA money into it, there is a way to effectively do so.
Take
a close look at your traditional IRA. How much of it is building tax-deferred
wealth for you?
Less than meets the eye.
If
you are in, say, a 40% tax bracket, then no matter how large your IRA gets to
be, when it comes time to take a distribution, 40% will go to the government.
Your ability to postpone that event won't change the nature of it. In effect,
the government now owns 40% of your IRA, and you own only 60%. If there is,
for the sake of round numbers, $100,000 in your IRA, only $60,000 is working
for you.
Fortunately,
there is a way to buy out the government's share. It's a Roth conversion. You
pay the tax now, so that eventually your withdrawals will be tax free. The
result: the assets you own directly decline by $40,000 (the money you spend
to pay the tax bill on the conversion); and the amount in the IRA that is
working exclusively for you increases by $40,000.
That's
a big improvement, because the net effect is to move capital out of a
tax-paying environment and into a tax-free environment where all of the earnings get
reinvested. To continue the example, the effective size of your IRA increases
by two-thirds ($40,000/$60,000). That's two-thirds more money doing the happy
work of tax-free compounding for your benefit.
You
can do the same with a solo 401(k) – effectively plump it up through a
Roth conversion.
The
financial logic of a Roth conversion is compelling. The case is even stronger
if you first restructure your IRA as an Open Opportunity IRA. The Open
Opportunity structure starts out as a big idea – radically greater
investment freedom – and then gets bigger.
Instead
of being restricted to the menu of investments allowed by your existing IRA
custodian, your IRA would own a single asset – a limited liability
company that you manage. Then you would roll over the investments from your
existing IRA into the new IRA and then into the LLC. As Manager of the LLC,
you would have the choice of keeping the existing investments or switching to
real estate, gold coins, equipment leasing or almost anything else.
That's
the investment freedom. In addition, by designing the LLC appropriately,
significant savings on the cost of your Roth conversion may be possible..
You
can learn more about the Open Opportunity IRA in "The Year of the
Roth," in the June 2010 edition of The
Casey Report.
Time to Plan
Deferred
annuities, cash value life insurance and retirement plans – these are
the ready vehicles for protecting the purchasing power of the cash you need
for portfolio safety during times of rapid inflation. They do the job by
reinvesting money market yields, which tend strongly to track inflation
rates, without loss to current tax.
Of
course, the three alternatives aren't exclusive; you can use more than one.
Which of them would be best for you depends not just on their characteristics
but on your individual circumstances. Now, before CPI inflation starts making
double-digit headlines, is a good time to start
weighing your choices. Even if you don't like any of the choices, any of them
will be better than letting your cash rot.
Contributing Editor Terry Coxon is president of
Passport Financial, Inc., and for over 30 years has advised clients on legal
ways to internationalize their assets to optimize tax, wealth protection and
estate planning goals.
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Terry Coxon
The Casey Report
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