Tax Exempt State and Municipal Bonds

A very simple and popular way to avoid taxes on investment income is to just put everything into tax exempt bonds.  For those who have no other income, it isn't even necessary to file a federal income tax return.  However, unless all of the exempt bonds are issued by the state of the investor (or unless the investor lives in a state with no income tax), a state income tax return may be necessary. 

The danger of putting all your money into exempt bonds is the same as the risk of putting too much money into any single investment or type of investment. If interest rates go up rapidly, you could lose a great amount of money. A lot of cities, counties and states are in serious financial trouble. Knowledgeable investors are extremely cautious about exempt bonds.

The basic fallacy of tax exempt bonds as a way to avoid taxes is that such bonds are subject to a "hidden tax".  The hidden tax is in the form of a lower rate of return to the investor.  Although the lower rate varies compared to taxable bond rates, the tax exempt bond usually pays about 30% less than a taxable U.S. bond of comparable duration. 

EXAMPLE:  A $100,000 U.S. bond with a 20 year maturity might be issued with an interest yield of 7% per year.  A triple A exempt bond maturing in 20 years is likely to be issued with an interest yield of 5% per year.  The exempt bond investor gets 30% less than the investor in the taxable bond. 

For a specific example, U.S. bonds with a 10 year maturity were yielding 7.8% near the end of 1989.  Tax exempt Aaa bonds with a 10 year maturity in Kansas and Missouri were averaging about 6.25%.  On $100,000, the exempt bond holder would get $6,250 a year.  The U.S. bond holder would get $7,800 a year.  The difference was almost 20%.  Thus, an investor in the 28% or 31% federal tax bracket could make slightly more (after taxes) with the exempt bonds than with the U.S. bonds.  The U.S. bond investor in the 28% bracket would pay $2,184 in taxes on $7,800 of interest, leaving $5,616 after taxes.  The exempt bond investor would end up with $6,250 after taxes.  Thus, the exempt bond is better than the taxable bond, but not by much. 

An investor in the 15% federal tax bracket would make more (after taxes) with the taxable bonds.  On $7,800 of interest, the 15% bracket investor would have to pay $1,170 of federal taxes, leaving $6,630 after taxes.  The exempt bond owner would get $6,250 after taxes. 

Exempt bonds were much more attractive when the top tax rates were as high as 70%, or even when top rates were 50%.  But with top rates of 28% to 31%, exempt bonds are harder to justify.  The "game" isn't won by not paying taxes. The game is won by having more financial resources for your retirement or for your family. That means having more after taxes. With exempt bonds, that rarely happens. 

Capital Gains

If you buy exempt bonds at a discount and hold them until maturity, you may be surprised to discover that the gain on the redemption of the bonds is a taxable capital gain. Thus, you might buy 6% exempt bonds with a maturity value of $1,000 for as little as $800. Instead of getting a 7% or 7.5% tax exempt yield, you are really getting a 6% yield and a 1.0% or 1.5% tax deferred yield. If tax exempt bonds are worthwhile for you, buy them at par when you can so that all of the yield is tax exempt. 

An exception applies in the case of "original issue discounts", which occur when a bond is originally sold at less than its maturity value.  That type of discount must be taken as income over the term of the bond.  However, since the bond is a tax exempt bond, the additional income arising from the original issue discount is also tax exempt.  When the bond matures, there is no taxable gain. 
 

Copyright, 2003, Vernon K. Jacobs

Vernon Jacobs is the Editor/Publisher of The International Wealth Protection Reports, which are a collection of research reports on legal methods of asset protection and tax avoidance. Further information on this subject is available at http://www.offshorepress.com/  Jacobs is a CPA who has worked as a free lance tax and financial author/editor since 1977. Details about his credentials and experience are online at http://www.offshorepress.com/vkjcpa/  

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