Tax-Free or Taxable Interest?

Bay Area Tax Attorneys – A frequent tax strategy question is whether it is better to invest for tax-free or taxable interest. Generally, taxable interest will provide the greater return, but this may not hold true after taking into account taxes on the income.

Therefore, the question is really which provides the greater “after-tax” return.  Generally, interest derived from “municipal bonds” is tax-free for federal purposes and also tax-free for a particular state if the bonds are issued by that state or its local governments. In addition, interest from U.S. Government Bonds cannot be taxed by any state.

The following are issues related to making a decision on taxable or tax-free income:

• Municipal Bond Interest – Interest earned from general purpose obligations of states and local governments, which are issued to finance their operations, are generally tax-exempt for Federal purposes. However, the various states usually only exempt interest from bonds issued from the state itself and local governments within the state. Hence, there are two categories of municipal bonds, namely the tax-free Federal and state and the tax-free Federal only. Individuals can invest in municipal bonds by directly purchasing a bond or through funds that invest in municipal bonds. Some funds invest in bonds issued in a particular state only, providing residents of that state with income that is excludible on their state’s return.

In general, tax-free bonds are likely to be more attractive for taxpayers in higher brackets, since they receive a greater benefit from excluding interest from income. For lower-bracket taxpayers, on the other hand, the tax benefit from excluding interest from income may not be enough to make up for the lower interest rate generally paid on this type of bond.

Even though municipal bond interest isn’t taxable, it must be shown on the return. This is because tax-exempt interest is taken into account when determining the amount of social security benefits that is taxable, and may affect the alternative minimum tax computation, as well as the earned income credit, investment interest deduction and sales tax deduction.

• Tax-Deferred Retirement Accounts – It generally doesn’t make sense to buy and hold municipal bonds in your regular IRA, Keogh, or 401(k) plan account. The income in these accounts is not taxed currently, but once you start making withdrawals, the entire amount withdrawn is likely to be taxed even though it includes income from tax-free sources. Thus, if you want to invest your retirement funds in fixed income obligations, it is generally advisable to invest in higher-yielding taxable securities.