All the money the Federal Reserve has pumped into the economy is not leading to higher prices yet. Fed officials say they will be able to withdraw the excess liquidity before it leads to inflation. If so, it could be the first time a central bank successfully made such a reversal. Investors are concerned the money will lead to sharply higher inflation within a few years.
The traditional inflation hedge is gold. There are several ways an investor can hedge against inflation with gold. These investments have different tax treatments, and you should consider the tax picture before deciding how you want to hedge against inflation.
Bullion. There are several ways to buy bullion. You can buy gold bars directly. You can store the bars yourself or have them stored at a facility. Bullion coins, such as Krugerands or American Eagles, also are a way to own bullion.
Exchange-traded funds are the most liquid way to own bullion. There are two ETFs that buy and store bullion. You can buy and sell shares in an ETF on the stock exchange. The ETFs charge annual expenses of 0.40% and return very close to the price change in bullion minus the expenses. The big advantage of the ETFs is the liquidity. You can sell the shares as quickly as any stock can be sold and generally not worry about premiums, discounts, or dealer markups. The two bullion ETFs are iShares COMEX Gold (ticker: IAU) and SPDR Gold Shares (GLD).
Bullion is a collectible under the tax code. That means it is ineligible for long-term capital gains treatment. All gains on bullion are taxed at the 28% tax rate.
Collectibles, including bullion, also cannot be owned in an IRA. The purchase of a collectible is a prohibited transaction and is treated as a distribution to the owner. The amount is included in the owner’s gross income, and there is a penalty for each year the investment stays in the IRA. If the owner is under age 59½ the purchase not only is included in gross income but is subject to the 10% early distribution penalty, unless the owner qualifies for an exception.
The IRS has issued some private letter rulings, however, holding that ETFs can be owned by IRAs. The IRA is considered to have purchased shares, because the shareholder has no divisional interest in the bullion and cannot force a distribution of the bullion. The ETF shares are taxed the same as shares of corporate stock or mutual funds.
Futures. The PowerShares DB Gold ETF (DGL) owns gold futures instead of bullion. The basket of gold futures contracts should have essentially the same return as bullion, though there are anomalies in the futures markets that cause deviations.
There are important tax differences for futures investments. The futures ETF is taxed the same as an individual futures position. All gains are 60% short-term and 40% long-term, regardless of the holding period. The combination is maximum tax rate under current law of 23% in the highest tax bracket.
In addition, each year end the gains are marked to market. The investors must realize the gains whether or not they sell. There is no deferral of taxes beyond year end.
You can own individual futures contracts, but most investors find it easier and safer to have a manager or fund buy and roll over the contracts.
Futures through ETNs. In addition to ETFs, exchange-traded notes (ETNs) are available to investors. E-TRACS UBS CMCI Gold (UBG) actually buys more than a dozen contracts with different expiration dates spread over as long as three years. This method is supposed to mitigate some of the anomalies and short-term events that occur in futures markets. The Elements MLCX Gold TR (GOE) holds a near-month contract on a gold index and rolls it forward each month.
The investor in an ETN does not own the underlying asset. An ETN is a debt note in which the note issuer owes the investor the initial investment plus or minus the return of the index. If the firm issuing the ETN has financial difficulties, the note might not be paid in full. Bankruptcy could result in a complete loss.
The tax treatment of ETNs is uncertain. Most investors treat the notes the same as stocks for tax purposes. But the IRS is reviewing its position on ETNs and might argue they are taxed like futures contracts or in some other way.
Equities. Instead of investing directly in bullion or futures, an investor can purchase the shares of miners and producers of gold. Shares of gold mining companies are far more volatile than the price of bullion, because mining companies have built-in leverage. Once the fixed costs of mining are covered, most of each dollar increase in the price of bullion goes to profits. Likewise, most of each dollar decline in bullion reduces profits. In addition, the miners tend to borrow to finance their production, and that increases leverage.
Gold mining shares could be influenced by factors other than the price of gold. General stock market trends and economic conditions can influence the price of shares. For example, a new credit crunch that restricts miners access to capital could reduce production and profits even if gold bullion is soaring.
An advantage for IRA investors is the shares of gold mining companies are treated the same as other stocks. Though bullion itself is a prohibited purchase, gold mining company shares are not prohibited or penalized.
For non-IRA investors, the gold mining shares also are treated the same as other stocks. If held for more than one year they qualify for long-term capital gain treatment. Shorter holding periods result in short-term capital gains. Losses also are deducted the same as other capital losses.
Gold mining shares can be purchased individually, through open-end mutual funds, or through ETFs.
Gold is one of the prime inflation hedges for investors. The returns earned vary depending on the choice of investment vehicle. Each vehicle also has different tax treatment, so investors’ after-tax returns can differ significantly even when the investments have the same pre-tax returns.
RW June 2009.