Tax-free income! Nearly every day, mail to this column brings urgent requests for ways and means to reduce one's income tax. One common way is to invest in municipal bonds or in shares of a mutual fund that invests exclusively in municipals.
As attractive as tax-free interest may be, look at these potential problems, too:
* Do you really benefit from tax-free interest? You can quickly figure your break-even point. Recognize that interest from municipal bonds is significantly less than from Treasury or corporate bonds. When interest is tax free, issuers of municipal bonds pay less interest. In the market at this writing, well-rated municipals are yielding about 10 percent, and corporate (taxable) bonds are yielding about 14 percent. If you divide the tax-exempt interest rate by the difference between your marginal rate and 100, you can find the equivalent rate of taxable interest you could earn and still retain the same number of spendable dollars. For example: If the 10 percent tax-free interest is paid to you and your marginal tax bracket is 32 percent, the break-even point is 10 percent divided by 68 (100 minus 32) -- answer, 14.71 percent. Thus, a corporate bond paying 14 percent would yield slightly less after-tax income than a municipal bond paying an even 10 percent. At any marginal tax bracket higher than 32 percent, tax-free interest at 10 percent would provide more spendable dollars than the roughly 14 percent interest on corporate or US Treasury bonds. Your marginal tax bracket is the rate you pay on the last increment of income.
* Not all municipal bond interest may be tax free. Although all of the interest from municipals is free of federal income tax, some or all of the interest may be taxable by the state. Generally, if you buy municipal bonds issued by your state or any of the taxing units within the state, the bonds will not be subject to state income tax. However, if you buy municipals from some state other than the one where you live, you could be liable for state income tax. Of course, if your state levies no income tax, you need not bother with this precaution. Determine your state income tax liability, if any, before you buy shares of a tax-free mutual fund.
* Risks can be substantial when investing in municipal bonds. Many of the large issues are rated, with AAA (or Aaa) being the highest rating. But many smaller issues by school districts, sewer districts, toll bridges, or port authorities may be too small to be rated. AT one time potential defaults by New York City and more recently by other cities have scared off some investors, and interest rates have risen as partial compensation for the added risk.
Other clues can alert you to risks: General obligation (g.o) bonds are usually less risky than revenue bonds. A g.o. is a debt subject to the full faith and credit of the issuer, such as a state or city. Revenue bonds depend on the income from a toll bridge or similar authority for the cash needed to pay both the interest and principal of the bonds. Buying shares of a tax-free mutual fund shifts most of the burden of picking creditworthy bonds onto the fund managers, who have access to more sources of information than you may have in evaluating bond issuers.
* Municipal bonds are currently heavily discounted. That is, prices are often less than their face value, because of low coupon rates. Discounted municipal bonds could be brought now for their tax-free yield and sold later if and when interest rates deline for a long-term capital gain (if held longer than one year). Any capital gain from the sale of bonds is taxed at the federal level.
Municipal bonds may have a legitimate place in your diversified portfolio, but don't allow the glitter of tax-free income to blind you to the basics. Your aim should be to gain the maximum assured spendable dollars from your investment with acceptable risk.