Investing to lower your tax bite; there are moneymaking ways to stop Uncle Sam from gorging on your profits.

There are moneymaking ways to stop Uncle Sam from gorging on your profits.

TODAY'S NATIONAL CRISIS ISN'T a World War: It's a great, and growing, tax bill. Uncle Sam doesn't want you anymore--just your money. Thanks to Clinton's 1993 tax hike, the top federal rate is now 39.6%. Add in state and local taxes, and the bill climbs, with residents of high-tax states like California, New York and Minnesota forking over close to half of their income to the government.

In this era of low interest rates, it's particularly disheartening to find Uncle Sam asking for an ever-bigger chunk of your investment income. But you can fight back--with a range of investment strategies designed to boost the after-tax return on your portfolio. Among them: tax-deferred retirement plans, Series EE savings bonds, tax-free municipal bonds and stock investments that emphasize capital gains over dividends.

Nearly every investor can profit from one or more of these strategies, subject to one caveat: Never choose an investment simply because it is tax-free or tax-deferred. Make sure it fits your overall savings and investment objectives. "Taxes should always be a secondary consideration," says Louis A. Holland, chief investment officer of Holland Capital Management in Chicago.

THE RETIREMENT ADVANTAGE

The first rule of tax-wise investing is to maximize contributions to your retirement plan. IRS-approved plans, such as individual retirement accounts (IRAs), Keogh small-business plans and 401(k) employee plans, let you sock away pre-tax dollars and defer taxes on the investment income until you take the money out, usually after reaching age 59 1/2.

"Retirement plans are the best deal going in America today for investing," says H. Lynn Hopewell, president of Monitor Group in Falls Church, Va., and editor of the Journal of Financial Planning. The most alluring are employee plans, such as 401(k)s, where the employer matches a portion of your contributions. "I've seen plans where the match is 50%," says Hopewell. "The returns on that investment are astronomical."

Even without employer-matching, retirement accounts are hard to beat. Let's say you can afford to invest $2,000 a year. If you're investing in a taxable account, and you're in the 36% tax bracket, that $2,000 would melt down to $1,280 after taxes. But if you stash it in a tax-deferred account, the whole $2,000 is available.

Then, there's the power of tax-deferred compounding. Assume you could earn an average of 8% a year on your account. Assume also that you are 39 1/2 years old; you have exactly 20 years to save.

At the end of 20 years, the taxable investor has $42,865, and the tax-deferred investor has $91,524-more than twice as much. Even if the tax-deferred investor immediately withdrew the entire amount and paid taxes on it at 31% (the current marginal rate for that amount of income), she would still have $63,152-some 47% more. And in reality, most retirees would be unlikely to withdraw the entire sum at once.

Another way to shelter investment income--but not contributions--from current income taxes is to buy an annuity. Sold by insurance companies, annuities share many features with IRAs. Investment income compounds tax-free, and there are penalties for withdrawal before age 59 1/2. Annuities also have insurance features that guarantee a return of principal to beneficiaries. Annuities are most attractive to conservative investors who want protection against principal loss and high-income investors who want to shelter more income than IRAs allow. Shop carefully, however, because the insurance feature of annuities is expensive, generally costing about 1.25% of your annuity investment a year. Also, most annuity contracts have stiff back-end loads (commissions due if you cash in the investment in a specified time period). These generally start at 6% and expire only after you've held on to the annuities for six or more years.

THE ALLURE OF MUNI BONDS

The purest tax-free play for Americans is municipal bonds, the debt of state and local governments. Most interest income from muni bonds and muni bond funds is exempt from federal taxes. (Uncle Sam permits the exemption to reduce borrowing costs for states and localities.) If you live in the state issuing the bonds, you may be exempt from state and local taxes as well.

One caveat, important for high income taxpayers: Interest on some muni bonds--mostly those issued for economic development purposes, rather than civic improvements--is subject to the federal alternative minimum tax.

Muni bonds offer a combination of low risk and relatively high returns. Because munis are backed by the taxing power of issuing government, defaults are rare --only about a dozen flop out of the hundreds of thousands issued during the last 40 years. Munis also are subject to risks from fluctuating interest rates and from being called before maturity.

To take advantage of last year's plunge in interest rates, states and localities sued $289 billion worth of municipal bonds, up 20% from the preceding year and a stunning 44.5% from 1991. Added to the supply of existing munis, the new issues produced a market glut--and very favorable prices for investors. "Tax-exempt bonds and bond funds offer a considerable premium compared to other fixed-income investment alternatives," says Paul C. Williams, vice president of John Nuveen & Co. Inc., a major Chicago-based muni dealer.

For example, in January you could purchase a tax-exempt bond or fund yielding 5.5%. If you are in the 36% tax bracket, that's equal to a taxable return of 8.6%. But taxable bonds were yielding much less: about 6.25% for Treasuries and 7% for blue-chip corporate bonds.

There are four ways to own munis:

* Open-end mutual funds. The most popular choice for individual investors, these are diversified portfolios that can issue and redeem shares as necessary to meet demand. They are the least expensive option--a minimum of $1,000 at Nuveen and many other dealers. Because their holdings are diverse and because their professional managers are constantly adjusting the mix, mutual funds are less risky than individual bonds.

* Closed-end funds. These portfolios are diversified but the number of shares is fixed, and they are bought and sold on stock exchanges. Because managers don't have to hold cash to meet possible redemptions, more funds can be invested and yields can be slightly higher than for open-end funds. Closed-end funds can also boost yields through leveraging (selling preferred stock in the low-yielding short-term market to buy higher-yielding bonds of longer maturities), which is forbidden for open-end funds. Your minimum investment will be slightly higher, averaging $1,500, plus brokerage fees.

* Unit investment trusts. These small, targeted vehicles have fixed portfolios of about five to 20 bonds. They are aimed at investors who want to tailor a trust's risk profile against their individual needs. In particular, they are designed to protect against call risk for 1 0 years or so and to return principal in a way that can be predicted. The usual minimum investment is $5,000, and they are marketed to more sophisticated investors.

* Individual bond issues. Most localities issue munis; the smallest denomination is typically $5,000. Don't try to make up your own portfolio unless you have at least $25,000 to invest. Dealers say that's the minimum needed to acquire a range of bonds with diverse characteristics. Otherwise, individual bond issues have the most exposure to every kind of risk. They are recommended only for very sophisticated investors with the time and expertise to manage risk and to organize expected returns according to their precise needs.

Obviously, the higher your tax bracket, the larger the potential advantage of munis. But they're not just a rich person's investment. Munis are worth considering as long as their return is better than your after-tax return from comparable alternatives.

To figure out whether a muni bond or fund is a good deal for you, calculate its equivalent taxable return using the following equation:

TEY = TFY/(1.00 - YTR)

Translated, this means that your taxable-equivalent yield (TEY) equals the tax-free yield (TFY) divided by your tax rate (YTR) subtracted from 1. For example, if you are in the 28% federal bracket, a tax-free yield of 5.5% equals 7.3%. (The equation would look like this: 0.073 = 0.055/(I.00 - 0.28).

As with all investments, research your muni purchases very carefully. Check with a professional adviser, such as a broker or investment planner, for help.

SERIES EE SAVINGS BONDS

Savings bonds fell from favor in the 1970s, when soaring inflation overtook their relatively low, and fixed, returns. But the U.S. Treasury responded with floating-rate bonds, including Series EE bonds targeted at small investors. The minimum investment is $25; you can buy them at most banks and sometimes through payroll deductions; and interest is exempt from state and local income taxes. The guaranteed minimum interest rate on bonds held for as few as six months is 4%. Bonds that were held for at least five years are earning 4.25% (as of April 1994).

In the fiscal year that ended last September, Americans bought $17.3 billion worth of Series EE bonds, up 27.3% from the prior year. Among their other attributes, these bonds offer you the chance to defer federal taxes on the income until it is realized. "People may choose when they purchase the bond to not declare interest earnings as they accrue, so earnings are tax-deferred until you redeem the bond or it matures, whichever comes first," says Sheila Nelson, of the Treasury Department's Savings Bond Division.

Series EE bonds are sold for 50% of their face value--$25 for a $50 bond. They reach face value in 18 years and earn interest until final maturity in 30 years. Subject to the minimum guarantee of 4%, the rate is set annually and equals 85% of the previous six months' average on Treasury securities, with five years remaining to maturity.

These bonds offer one other advantage for middle-income investors: If they are purchased by adults, such as parents, to pay for a child's education, the income is exempt from federal income tax. This exemption, however, is phased out for people with higher incomes. In 1994 the exemption is worth less for taxpayers with adjusted gross income of more than $41,200 (single) or $61,850 (married filing jointly), until it gradually disappears for incomes of $56,200 (single) and $91,850 (married).

The bonds' 4% minimum rate can make them attractive even for short-term investors because this is a substantially better yield than banks are offering for six-month certificates of deposit.

CUTTING TAXES ON STOCK EARNINGS

If you buy individual stocks, you can reduce the tax bite by investing in companies that retain most or all of their earnings, rather than paying out large dividends. Why? Because the federal government taxes dividend income at a different rate than capital gains.

Income stocks, such as utilities, return the lion's share of earnings to investors in the form of dividends. Growth stocks retain all or most of their earnings because companies invest the profits to help the business grow. You realize most of your earnings on growth stocks only when you sell them. All else being equal, you would choose between growth and income stocks depending mostly on whether or not you need current income.

But all is not equal, thanks to the tax code. "The change in tax law [in 1993] favors companies that plow their earnings back into the company rather than pay them out in dividends," says Holland, whose investment firm specializes in such stocks. "Therefore, these |growth' companies basically have more appeal."

Dividends are treated as ordinary income, and they're taxable at your top marginal rate for the year in which they are paid. Profits on the sale of stock held for more than one year, however, are taxed at a maximum of 28%, and taxes don't come into play until you sell the securities. Therefore, you can keep more of your investment profits if they come to you in the form of capital gains.

KEEPING PRIORITIES STRAIGHT

Remember that the best ways to lower your taxes are not necessarily the most complicated. Before you build a portfolio of munis or weigh the growth and income potential of individual stocks, take a hard look at your retirement accounts. For many individual investors, they still offer the best tax breaks around.

"Very often, people don't take maximum advantage of these plans," notes Gale P. McEvilley, a certified financial planner with L.J. Altfest & Co. in Manhattan. "It's something we always recommend they do."

Avoid the mistake of putting munis inside a tax-sheltered account. Taxable bonds pay higher yields than municipals, and since you're not paying current taxes on the difference, they provide a much greater return than municipals.

As you move beyond retirement accounts, be sure to review potential investments with your accountant as well as your financial adviser. Never let a tax-savings pitch seduce you into an investment that you wouldn't choose otherwise. But don't ignore the issue either. You have to pay taxes, but you don't want to pay a penny more than you have to.

CHARITY BEGINS AT HOME

How to get a bigger tax break from your charitable gifts

"If you're planning to make a gift to a not-for-profit [enterprise], you could liquidate securities, take the cash and make a contribution--but that could be a mistake," says Edward Singleton, chief financial officer of Ariel Capital Management Inc. in Chicago.

The reason: Selling the securities at a profit would trigger a tax liability on the gain. But if you give the securities directly to a charity, you can claim a deduction for their current value while escaping the tax.

For example, suppose you make a gift of $1,000 to your church or another IRS-approved charity. The tax deduction, in the 36% bracket, would reduce your tax bill by $360, making your out-of-pocket cost $620.

Suppose instead that you give the charity $1,000 worth of stocks, for which you paid $750. You receive the same deduction, but your out-of-pocket cost is $250 less.