Paying income tax has become such a burden to many retirees facing increasing pressures from inflation that the unwise use of tax-free municipal bonds may be increasing. The basic question is: Which course leaves more spendable dollars in your pocket -- tax-free municipal bonds or some other investment that produces a higher return that is taxable?
Marginal tax rates affect your decision. Marginal is an economics term that refers to the last increment of something -- income taxes, wages, return on investment, etc. Applied to income taxes, marginal means the tax rate on the last or top increment of income. If you earn $20,000 at a job or from a pension and social security plus $1,000 from stocks and bonds, the marginal tax rate is the percentage of tax you pay on that last $1,000.
If the $1,000 represents a 10 percent yield on $10,000 and is taxed at the top or marginal rate of 24 percent, you would have $760 remaining after paying $ 240 in taxes. The after-tax return is 7.6 percent on the $10,000 in spendable dollars.
If you had invested the $10,000 in a municipal bond tax-free income fund that yielded 6 percent, after-tax earnings would be $600. In this example you're better off to invest your cash in a higher-yielding mutual fund, stocks, or certificates of deposit and pay the income taxes due than to invest in the tax-free fund. Avoiding taxes can be a laudable goal, but not if it means fewer dollars in your pocket.
Some investors misfigure the trade-off by considering their average tax rate instead of their marginal tax rate. Adjustments, deductions, and exemptions reduce gross income to taxable income. The lowest bracket is 14 percent of taxable income, and rates increase in jumps as taxable income rises. Your total tax bill divided by total taxable income is your average tax rate; it will be smaller than your marginal rate. When considering taxable or tax-free income from alternative investments, always use your marginal rate.
To figure a break-even point where taxable income produces the same after-tax return as tax-free income, subtract your marginal tax rate from 1.00. Divide the tax-free return by the difference to find the equivalent taxable income. For example, with a marginal tax rate of 24 percent, subtract 0.24 from 1.00 for 0.76 and the answer, 7.89 percent, is the equivalent rate of return to yield 6 percent after-tax income. Even the simplest pocket calculator performs this calculation easily.
wo types of municipal bond mutual funds offer tax-free income for small investors -- the long-term, managed fund and the newer limited-maturity tax-free just over one year, managers hope to avoid the ups and downs of asset values. All income dispersed by either group of funds is passed through tax-free to shareholders.
Three no-load limited maturity funds are Warsick Short-Term Municipal Fund (Drummers Lane, Valley Forge, Pa. 19482), Scudder Tax-Free Money Fund (175 Federal Street, Boston, Mass. 02110) and Chancellor Tax-Exempt Daily Income Fund (Bache Halsey Stuart Shields, 100 Gold Street, New York, N.Y. 10038). A sampling of the more numerous long-term municipal bond funds is Bullock Tax-free Shares Inc. (One Wall Street, New York, N.Y. 10005), Dreyfus Tax-Exempt Bond Fund (767 Fifth Avenue, New York, N.Y. 10153), and Kemper Municipal Bond Fund ( 120 South LaSalle Street Chicago, Ill. 60603). For a longer list of both types of funds, send for a Membership List of the Investment Company Institute, 1775 K Street, NW, Washington, D.C. 20006.