Expert: Doug Ingram - 2/27/2007

Question
Thanks. I had thought about zero coupon bonds but, as I understand it, the eventual payout from this type of investment is still taxable as ordinary income, right? I was hoping to find something that resulted in qualified dividends or long term capital gains. Of course, the tax-free versions address that but I assume have significantly worse payout. Is that a good assumption?
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This is perhaps a peculiar question and maybe not a good match to your interests, but I'll try anyway. I'm looking for an investment that provides reasonable long term gains with bond-type diversity over equities but pays off in primarily capital gains and/or deferred dividends rather than income.

I have recently set aside money in a flip CRUT and am interested in maximizing the gain in principle over the next 10 years before it "flips" and I begin to withdraw a fixed percentage. I figure building the principle during this period without taking much, if any distribution, benefits both me and my eventual charitable beneficiaries. Since I don't need the income now it should make what I get in retirement greater and most likely the ultimate donation greater as well. As I understand it I must distribute annually any income generated in the CRUT before "flip" (up to the % established in the CRUT) but not capital gains. I'm not sure about dividends but I believe they also must be immediately distributed. To make matters worse for income production, I will eventually pay taxes on ordinary income first, then capital gains and qualified dividends, then tax free. As I funded the CRUT with appreciated stock, I'll probably never get lower than the long term capital gains tax rates but I'd prefer to minimize the ordinary income in retirement as I have other sources, e.g. traditional 401K & IRA distributions, that will increase my ordinary income. So I'd prefer to build capital gains and/or qualified dividends that don't show up before the "flip".

However, I also want to have a well diversified portfolio, not only because I believe that investing in bonds provides good balance but also because of my fiduciary duties to have a reasonable investment policy. Thus I'd like something that provides the diversity of bonds without throwing off income. I could invest up to $250K in this direction. Any ideas?

I suspect there might be others that currently make a good income but don't need or want taxable income at the moment and would like to have some bond-type diversity in their portfolio. So I hope this is generally interesting enough that you will respond. Thanks.
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Sorry - been out a few days.

The first thing that comes to mind is strip bonds (zero coupon).  These can be bought out to 30 years at deep discounts.

There are also principal-only portions of mortgage product, though they pay sooner (have cash flow).  (A 30-year strip would not pay until maturity and liquidity isn't too bad.)

There are also tax-free zero-coupon discount bonds, but they might not apply to you for some of these investments and they do have more risk factors than government Treasuries and Agencies.

Your income (even though deferred) would be subject to market rates, so unless you laddered into your investments, you would be looking at 5 to 6 returns at best.

You should be able to buy about $410,000 worth of bonds right now for about 250K given a 10-year maturity.

With tax-free bonds, you can probably get close to that bogey as well.

Another thought is the inflation index bonds.  They have smaller coupons and accrete par value until maturity based on inflation.  Of course, this is an inflation play as well, and they could out or under-perform fixed rate product.

Answer
From a tax standpoint, everything depends on how you set up accounts.  Those are questions for a good accountant.

If it's in a regular account, there will still be tax implications.  There may be products and funds that will get you there, but I only follow more traditional bonds.

A broker with a place like Fidelity might better answer product questions.

I do know that there are many Muni (tax-free) bonds that rival taxable yields even though they are not taxable.  The trick there is to do your homework and chose states/counties/cities that have good taxing authority and the ability to pay.  I would select a couple brokerage firms and compare offerings.  If you buy $25,000 or $50,000 blocks you can also diversify some risk.