Mo Vidwans
I don’t know too many people who don’t complain about paying income taxes; in fact I don’t know any. Paying taxes is a necessary evil (it is the law) that we all have to comply with. But, of course, that does not mean that we should let Uncle Sam have a free wheeling hand at it and pay more taxes than we need to. We owe it to ourselves to make sure of two things: that we file the income tax paperwork every year (consequences are dire if we don’t) and that we minimize our tax obligation as much as we can legally within the rules established and the existing laws on the books.
There are many ideas and avenues open to us to reduce the taxes. Today, I am going to focus on tax-free investing which is one way of reducing or not having to pay taxes.
Generally, on any kind of passive income, like dividends, interests etc. we pay taxes, more or less depending on what the timeframe for the income is and what our income tax bracket is. Here is a simplified example: if we earn $1,000 in interest and our income tax bracket is 15%, then we pay $150 in taxes on that interest income and we actually keep $850. If we were in 25% bracket then we pay $250 in income taxes and keep only $750 for us to enjoy. The interest income is the same but depending on what our income tax rate is we keep less or more of that interest. Clearly the lower income tax rate folks have some advantage here.
Needless to say, in the menagerie of all the different investment strategies that are available to us, if avoiding taxes is our main goal, then we can choose certain investments; but I would think that it will not be reducing the taxes that we would be interested in but our main focus has to be how I can keep more. It is the after tax money we are after; this strategy is popularly known as “after-tax investing.”
Among the different possibilities, IRAs, 401Ks and similar vehicles are there but that is not I would concentrate on today. Granted those are tax avoiding vehicles and they do help us when we are young and need to reduce the taxes the most. But they are really not tax-free per se because we end up paying taxes on that money when we withdraw from those accounts. Hence we can call them tax delaying or tax postponing strategies. We hope, however, that we are in the lower tax bracket when the time comes to withdraw from those accounts.
Focus this month is on Municipal bonds and the income from them. Municipal bonds are issued by state and local governments in order to finance capital expenditures. Municipal bonds are generally free of federal tax because the interest from bonds issued by a state or a municipality is exempt from federal taxation. As an added benefit, most states will allow a state tax exemption if the owner of the bond resides in state of issue. However, if you purchase a bond outside your state of residency, it may be subject to both state and local taxes.
If you buy shares of a municipal bond fund that invests in bonds issued by other states, you will have to pay state income tax at least partially. In addition, while some municipal bonds that are in the fund may not be subject to ordinary income tax but they may be subject to federal, state, or local alternative minimum tax (yes, it still exists). If you sell a tax-exempt bond fund at a profit, there are capital gains taxes to consider. Bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall (and vice versa), which can adversely affect a bond fund’s performance. My recommendation always is to buy individual bonds and keep them to maturity.
Municipal bonds come in a variety of forms and should be selected by strict criteria based predominantly on the State’s or Municipality’s ability to service the debt (these financial ratings are readily available). It’s important to remember that the principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher yields also involve a higher degree of risk.
If you decide to invest in either type of tax-exempt security, consider the different options carefully. You can purchase individual bonds, which come in denominations of $1,000. Or you might consider investing in a municipal bond mutual fund, a portfolio of bonds in which you can invest for as little as $500. Municipal bonds can also be purchased through a unit investment trust, a closed-end portfolio of bonds with minimums of $1,000.
Often tax-exempt securities are the most favorable for those in higher tax brackets, so it’s important to determine whether buying them would be an advantageous move for you. To decide whether municipal bonds would be an asset to your portfolio, calculate the taxable equivalent yield, which enables you to compare the expected yield of the tax-exempt investment with its taxable equivalent.
For instance, if you are in the 28% federal income tax bracket and invest in a municipal bond yielding 5%, this is equivalent to investing in a taxable investment yielding 6.94%. If you are in the 35% tax bracket and invest in the same bond, it would be the equivalent of investing in a taxable investment yielding 7.69%.
Also be aware that tax-exempt income is included in the formula for determining taxes on Social Security benefits. In some instances, it may be necessary to limit your tax-exempt income by shifting to other tax-advantaged investment areas.
If they’re in line with your investment objectives, tax-exempt securities can be an excellent means of reducing taxable income.
