Considering bonds? Don't shortchange yourself just to spite the tax man

August 25, 1991|By Jonathan Lansner | Jonathan Lansner,Orange County Register

How can you make money by paying taxes?

If you don't make enough money to get the full tax break afforded those who own state or municipal bonds, switch to taxable investments from tax-free ones.

Many savers have flocked to municipal bonds -- or mutual funds and trusts that buy these bonds -- in recent years as the federal government limited ways investors can shelter money from taxes. Income from these bonds is typically free from federal taxes.

"There's a lack of knowledge," said Richard Ciccarone, director of fixed-income investments at Chicago-based Kemper Securities. "People think just because it's a muni, it's the best."

Lured by aggressive sales pitches that tug at savers' desires to beat the tax man, many savers own tax-free investments when they would be better off elsewhere.

Experts add that other factors also are at work. Some savers see it as a political statement. Others buy munis as a way to express civic pride. And there's a convenience factor, as well.

Jack Lemain, a bond-fund manager at the Franklin Group in San Mateo, Calif., said he keeps his child's savings in tax-free bond funds so he doesn't have to file a tax return for the boy.

"I know the yield is lower," Mr. Lemain said.

According to recently released Internal Revenue Service statistics for tax-year 1988 -- the latest available -- some 605,500 households with taxable income of $20,000 or less had tax-free bond holdings producing, on average, $4,250 in income.

This group, roughly 16 percent of the taxpayers with tax-free income, likely could have been earning more money -- even after paying taxes -- in other, taxable government bonds, tax and financial planning experts say.

The ranks of such investors swelled from 1987's 525,000. Meanwhile, the share of lower-income savers as a part of all tax-free bondholders fell slightly.

"There's a large emotional reaction against paying taxes," said William Loring, a bond-fund manager with the Colonial Group funds in Boston. "If people did the calculations, they might manage their money differently."

Unfortunately for investors, figuring what's the best bet in this taxable-vs.-tax-free debate isn't easy:

(1) Compare like investments -- those with similar maturities and credit quality -- when doing such tests. For instance, low-grade municipal bonds are not as safe as U.S. government issues, and accordingly they will pay higher rates in exchange for the added risks.

(2) Figure out your "marginal tax rate" -- the tax on each extra dollar. Those looking at "double" tax-free investments -- that is, bonds that spin off income that is not taxable for state and federal purposes -- need to reflect both tax rates in this calculation.

(3) Calculate either: (a) what a taxable yield is worth after taxes or (b) what taxable yield the investment must earn to beat the "tax equivalent" tax-free payout.

(4) Note that income on U.S. Treasury issues -- as well as mutual funds that own a majority of such securities -- is free from state taxes.

(5) Retirees should check up on how tax-free income affects the taxability of their Social Security payouts.

What makes the math harder is that it constantly changes.

Investors should update this calculation at least once a year to take into account changes in interest rates, tax rates and their income.

Obviously, few savers go through these gyrations regularly.

Yields on California tax-free money-markets, for example, are so low that only the wealthiest people would be better off owning these accounts instead of taxable money funds. Nevertheless, tax-free money funds continue to hold billions of dollars.

Marketing campaigns for tax-free investments make this even more confusing.

Typical sales pitches for municipal bonds have sexy rates in big, bold type. The only catch, spelled out in small print, is that an investor would have to be in both the highest federal and state income tax brackets to see such returns.

Here's an example of how all this works: A typical top-grade, long-term municipal bond is yielding 6.5 percent.

Savers in a high-tax state would have to get more than 10.6 percent on taxable issues to make them worthwhile after taxes are deducted.

To a couple making $50,000, that same muni bond is equal to a taxable yield of 9.8 percent. But to joint filers with income of $18,000, the tax-free bonds are equal to a 7.8 percent taxable yield.

The wealthy and middle-income couples might find it hard to beat the muni-bond yields unless they took some large credit risks. Long-term U.S. Treasuries, for example, are yielding about 8.3 percent.

But the lower-income family would be far better served by owning U.S. securities and paying taxes.

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