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On money

By HELEN HUNTLEY, Times Staff Writer

© St. Petersburg Times, published September 29, 2002

CDs protect principal but have other risks

CDs protect principal but have other risks

Q. I lost $50,000 of my nest egg in the stock market. I am considering putting my money in a five-year bank certificate of deposit. What risk, if any, would be involved in investing $60,000 with one of the out-of-town banks advertising high yields? Can I take yearly income off part of the money and let the interest accrue on the other part? How would this affect my taxes? I cannot afford to lose any more money, and I am running scared.

A. If loss of principal is the risk you are worried about, a CD is about as close to a risk-free investment as you can get. Putting your money in a CD in an out-of-town bank is not any riskier than putting it in a local bank, so long as both are covered by federal deposit insurance and your deposit does not exceed the insurance limits.

CDs do have other kinds of risk. For example, there is the risk that you will need the money before maturity and get hit with an early-withdrawal penalty. There also is interest rate risk. If rates go up, you'll be stuck with lower rates for the term of your CD. If they go down, you'll be glad to have your money locked up temporarily, but you will face lower rates when your CD matures and it's time to reinvest. Finally, there is the risk that your interest earnings will not keep pace with inflation.

A CD is a contract between you and the bank. The interest payment schedule depends on the terms of your contract. Generally, you can choose to have interest earnings paid out to you or reinvested. By splitting the money into two CDs, you can do both. Unless your money is in a retirement account, you will owe taxes each year on your interest earnings even if they are reinvested. You are taxed on withdrawals from retirement accounts whether they come from interest or principal.

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Q. I wish to give my nephew $25,000 now or within the next few years. Can you tell me how to do this with the least tax burden on him? Are there tax forms or instructions I will need?

A. There will not be any tax burden on him and probably not on you either. People who receive gifts don't have to worry about taxes unless the gifts involve tax-deferred property such as retirement accounts and savings bonds or appreciated property such as stocks or real estate worth more than their purchase price.

If you give any person more than $11,000 in one year, you need to fill out a gift tax form (IRS Form 709) to report the gift. This has no tax consequences to you unless your reportable gifts over your lifetime plus your estate will be worth more than $1-million -- and maybe not even then. If you are a millionaire, you definitely should talk to a lawyer about your estate plans.

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Q. Can I ask for a holding that has lost money in an IRA to be transferred to a non-IRA account, then sell it and take a capital loss to reduce income taxes?

A. Yes, you can make the transfer. No, you cannot take the loss. If you transfer shares of stock from an IRA to a non-IRA account, the basis you use to figure your future capital gain and loss is the value at the time of the transfer, not the original purchase price.

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Q. Can you tell me what telephone bonds are and whether they are suitable for senior investors?

A. Telephone bonds are bonds issued by telephone companies. Like all bonds, they are subject to interest rate risk, which means if rates rise, your bonds will be worth less. If you sell before maturity, you could get more or less than you paid.

The bigger concern for most investors is credit risk. Is the company financially strong enough to make all the interest and principal payments on time? If it isn't, and you've invested a lot of money in its bonds, you are in deep trouble. Even perceptions of financial difficulties affect the market value of a corporate bond if you want to sell before maturity.

Because of credit risk, it is extremely important to keep your investments diversified. As a general rule, bonds from a single issuer should never be more than 5 to 10 percent of your portfolio. Also, avoid concentrating your portfolio in a single industry such as telecommunications.

Online Money Map

The ability to screen a database of 11,000 mutual funds is one of the features available at Business Week Online (www.businessweek.com). Click on "tools and scoreboards," then "mutual-fund search."

-- Helen Huntley writes about investing and markets for the Times. If you have a question about investments or personal finance, send it to On Money. We'll try to answer those we think are of greatest reader interest. All questions must be submitted in writing, but readers' names will not be published. Send questions to Helen Huntley, Times, P.O. Box 1121, St. Petersburg, FL 33731.

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