Tax Free Municipal Bonds

State And Federal Tax Savings Cost You Money

I was recently embarrassed when a friend of mine asked if there were any tax free investments he could make that didn't involve a lot of watching over and provided an steady flow of interest or dividends, and I forgot about munis. I recommended Federal debt, such as tax free ibonds, notes or bills, because they are easily managed online through Treasury Direct and the are state tax free. Of course, if you're trying to limit your tax bill, beating your local sate out of their single digit percentage isn't going to make a whole lot of difference in the long run. When he did some research on his own and came up with municipal bonds as the ideal solution for his situation, I realized that I'd bought munis myself back in the earl 90's, but I'd forgotten all about them as my investment capital shifted into my tax deferred retirement accounts.

In one sense, tax free munis are more complicated than tax free Federal obligations, since the Federal debt is free from all but Federal tax, while the munis are usually only free from local taxes if you live in that locality. That's why when you look at tax free muni funds, you'll see them listed by state, like "Massachusetts Tax Free" or "California Tax Free." If you don't live in that state, they will be Federal tax free, but you'll still have to pay state, and maybe even city tax. Municipal bonds aren't 100% safe, cities have been known to default from time to time, but there are rating agencies to tell you if the credit isn't top notch, and muni funds that spread the risk around in your state to the point where you shouldn't have to worry about it.

Like all tax free investments, they are worth to people in high income brackets than to the working middle class. I compiled the following table from the IRS website for 2006, may be the same for 2007 when all is said and done:

Single Tax Rate Married Joint Filers Tax Rate Married Separate Filers Tax Rate Head of Household Tax Rate

To $7,550 10% To $15,100 10% To $7,550 10% To $10,750 10%

On $7,550 to $30,650 15% On $15,100 to $61,300 15% On $7,550 to $30,650 15% On $10,750 to $41,050 15%

On $30,650 to $74,200 25% On $61,300 to $123,700 25% On $30,650 to$61,850 25% On $41,050 to $106,000 25%

On $74,200 to $154,800 28% On $123,700 to $188,450 28% On $61,850 to $94,225 28% On $106,000 to $171,650 28%

On $154,800 to $336,550 33% On $188,450 to $336,550 33% On $94,225 to $168,275 33% On $171,650 to $336,550 33%

From $336,550 on up 35% From $336,550 on up 35% From $168,275 on up 35% From $336,550 on up 35%

So, lets take the extremes of a married joint filer in the 10% bracket and a married joint filer in the 35% bracket, both living in Massachusetts with a $100,000 portfolio of Massachusetts muni bonds, state and federal tax free. And lets say those munis pay out at 5% in the current year. On the $5000 of interest income, neither will pay any taxes to either the Massachusetts Department of Revenue or the Internal Revenue Service, but the savings are very unequal. The high income married couple is saving 35% Federal Tax plus 5.3% State Tax for a total of 40.3% of $5,000 or $2015. The return for the high income muni holder is equivalent to a taxable investment paying 8.375%.

Now lets consider the low income marries joint filer paying 10% Federal Tax plus 5.3% State Tax for a total of 15.3% of $5,000 or $765 dollars. The lower income individual making the exact same investment gets tax savings of just over a third of what the high income individual sees. The return for the low muni investor is equivalent to a taxable investment paying 5.90%. The low income investor can probably do better by buying AAA taxable bonds and paying the taxes, while the high income investor probably can't beat his 8.375% equivalent return without taking on more risk than a muni portfolio presents. So, the rich get richer!

I've written a bit about calculating interest rates and using the mortgage formula and I think I'm planning something on stock dividends and their tax implications, along with some other basic calculations that people should really take into account in their investing.

Calculating Mortgage Interest | Federal Tax Free I-Bonds | CPI-U and Inflation | Tax Free Munis | Buying T-Bills