How Can I Create Tax-Exempt Income?

When establishing a comprehensive tax planning strategy, one of the first steps is to understand tax-exempt securities and to determine whether an investment in these instruments is in your best interest.

Tax exemption on municipal bonds exists because the federal government is restricted from taxing the state government. Consequently, the interest generated by any bonds issued by a state, municipality or other local entity is exempt from federal taxation.

As an added benefit, most states will allow a state tax exemption (double exemption), if the owner of the bond resides in the state of issue. In fact, with the ownership of some bonds, you can receive a “triple tax exemption” by purchasing municipal bonds issued by the city in which you live, assuming the city levies a tax.

Municipal bonds come in a variety of forms. General obligation bonds are backed by the taxing power of the issuing entity. Revenue bonds are backed by the revenues generated from the project being financed by the bond issue. The backing behind individual bonds will directly affect their creditworthiness.

Municipal bonds should be selected by strict criteria based predominantly on the state’s or municipality’s ability to service the debt.

If you decide to invest in tax-exempt securities, there are a number of different choices to consider. You can purchase individual bonds, which come in denominations of $5,000. Or you can 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.

When considering a purchase of tax-exempt securities, you should consider the tax-equivalent yield of the prospective purchase, the taxation of your Social Security benefits, and your overall investment objectives.

By comparing taxable yields to tax-exempt yields, you can decide whether to invest in taxable or tax-exempt investments.

For instance, if you have a marginal tax bracket of 30 percent and invest in a municipal bond yielding 5 percent, this is equivalent to investing in a taxable investment yielding 7.14 percent.

If you are only able to find a taxable investment that currently yields 6.5 percent, you will be better off in the tax-exempt bond. If, on the other hand, you can find a taxable investment generating 8 percent, the taxable investment is a better alternative, assuming the investment risks are equal.

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-preferred investment areas.

Note that in some states you will have to pay income tax if you buy municipal bonds issued by other states. In addition, while some municipal bonds may not be subject to regular income taxes, they may be subject to federal, state, or local alternative minimum tax. If you sell a tax-free bond at a profit, there are capital gains to consider.

If they’re in line with your investment objectives, tax-exempt securities can be an excellent means of reducing taxable income.

© 2003 Emerald Publications

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