Scott Burns: Taxes aren't as menacing as you think

First, I want to protect the money from taxes as best as possible for growth to retirement. I am in the 15 percent tax bracket. Second, I want to protect it from a greedy, financially disastrous ex-husband when it comes to funding my children's college education.

An annuity would put the money in a retirement wrapping, but you pooh-pooh annuities. In addition, if I created a legitimate second job/self employment business, would I be entitled to create a SEP and funnel more of those dollars into that SEP and be better off than with an annuity?

- C.M., Chicago

A. There are two menaces here, and they may not be as bad as they seem. In most divorce agreements, financial ties between the former spouses are severed, with particular attention to present and future asse
ts. The ties that remain generally deal with child support, child education and, in some cases, alimony.

Your former husband has no direct way to get to your inheritance. He can only get to it indirectly by defaulting on promises he has made in the divorce agreement. If he does that, you may need to use some of your assets to fulfill the promises that he breaks - while using legal means to force him to fulfill the obligations. If he has shown a long pattern of financial irresponsibility, you should plan accordingly and encourage your children to contribute to their educations.

The other menace, the taxman, needs some rethinking. In the 15 percent tax bracket, there is little need to use tax shelters, and they should play virtually no role in your investment planning.

You can minimize your tax bite by using equity index funds such as the Vanguard 500 Index fund. Such funds generate very little dividend income and rare capital gains distributions. As I have demonstrated in past columns, the simple p
urchase of an index fund would have outperformed all but a handful of tax-deferred annuity sub accounts.

While all Standard & Poor's 500 index funds are not created equal, they are now available from a great many fund companies in addition to Vanguard. A search of the Morningstar database revealed 32 large capitalization stock funds with neither an up-front nor a deferred sales charge, an expense ratio of less than 0.5 percent, and a minimum purchase of $25,000 or less. Among the major no-sales-charge fund companies, Fidelity, Schwab, T. Rowe Price, Scudder and Strong offer them.

You can also go a step further in tax deferral by looking for a "tax-managed" index fund. Vanguard Tax Managed Growth and Income, which tries to offset realized gains with losses found elsewhere in the portfolio, has actually managed to do slightly better than the S&P 500 index over the last year, three years and five years.

If you are worried that the S&P 500 index is dominated by a handful of very large capit
alization stocks, you can offset it, somewhat, by investing in the Schwab 1000 fund - the 1,000 largest stocks account for about 90 percent of all market value in America.

In addition, a SEP-IRA is less than ideal for you. A SEP is for deferral of pre-tax income, and your inheritance is after-tax money. Instead, your first move should be to a Roth IRA, which will allow you to accumulate investment growth tax-free.

Q. I'm 35 and think I'll work at least another 25 years. I max out my 401(k) in blue chip stocks, equity income funds and stock index funds. I've bought a second home, which I rent out. Is there anything I should do to mitigate the risk of a major market slump due to millions of baby boomers retiring all at once?

- D.C., by e-mail

A. There isn't anything you can, or should, do today, and there may be no need to do anything in a distant tomorrow. I know the "demography is destiny" theory, but I also think that both retirement and investment patterns will change significantly over
the next few decades.

First, many people will work longer and retire later as they contemplate a life expectancy of 90 or 100 years.

Second, even those who retire at traditional ages are likely to strive to continue building their investments in retirement, knowing that their retirement will be a long one. In other words, I don't think a rush for the exit is inevitable.

Questions about personal finance and investments may be sent to: Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas 75265; or faxed to 214-977-8776; e-mail to scott@scottburns.com. Check the Web site: www.scottburns.com. Questions of general interest will be answered in future columns.