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Tax Exempt State and Municipal Bonds Legal Tax Angles: How to Save Taxes Without Going to Jail The interest you earn on bonds that are issued by states, counties, cities,
or political subdivisions of state or municipal governments, are free from
federal income tax. In most states that have a state income tax, bonds issued
by that state, or by government units within the state, are also exempt from
state income taxes. But if you live in New York and buy bonds issued by
Illinois, you will have to pay a New York income tax on the interest you
receive from the Illinois bonds. The value of tax exempt bonds is greater for investors
in the highest tax brackets. In effect, the lower rate
of interest is a form of “tax” that investors must pay. But if you are in the
35% federal tax bracket, a state bond that pays 6.5% interest will produce the
same after tax income as a corporate bond that pays 10% interest. That’s because you
would only end up with 6.5% after taxes from the corporate bond. If you are in
the 25% tax bracket, a tax-free bond that pays 4% would be equal to a taxable
bond that pays 6%. Exempt bonds, like all bonds, will decline in value when current interest
rates increase, and will increase in value when interest rates decline.
During periods of rising interest rates, such bonds are not a good
investment. Conversely, you can profit substantially by purchasing such bonds
when interest rates begin to decline. Under the 1984 tax law, any difference between the cost of a bond purchased
after the official date of enactment of the bill (July 18, 1984) and the
maturity value of the bond, must be adjusted over the time the bond is
outstanding. This new rule is not applicable to exempt bonds. The tax law imposes two significant limitations on tax-exempt bond holders:
First, you can’t deduct interest on money you borrow to buy or own
tax-exempt bonds. Second, if you receive any Social Security benefits, and if your total income is over $25,000 per year ($32,000 on a joint return), then up to 85% of your Social Security benefits could be subject to tax. The computation of the “total” income includes any tax-exempt interest. Thus, the receipt of tax-exempt interest could trigger a tax on otherwise tax-free Social Security benefits. You can obtain information about how to buy tax-exempt
bonds from most bond and stock brokerage firms. Expense loads
vary—expect to pay between ¾% and 3%. for shares of an exempt bond fund.
If you decide to purchase individual bonds, you should seek the help of a
specialist in tax-exempt bonds because they are difficult to evaluate and the credit worthiness varies greatly from
issuer to issuer. Copyright, 2003 |
Books and Services by Vern Jacobs
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