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Taxable Interest Versus Non-taxable Interest | Tax Tip of the Week | No. 52 August 4, 2010

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Examining Investment Alternatives – US Obligations and Municipal Bonds

Editors note: Before we dig into this week’s TTW, I want to acknowledge the 52nd tip – or a full year of Bradstreet’s Tax Tip of the Week! To those who have been with us from the beginning – THANK YOU. For those who have joined in along the way – WELCOME! We’d love to hear from you about what you like, don’t like and how we can improve. Shoot me an email or comment here. Happy Anniversary – We hope you’ve learned a few tricks and tips over the past year!

Savings Bonds can be a good choice  for reducing taxesInterest generated from your non-retirement investment accounts such as savings, money markets, CDs, and corporate bonds are all taxed at your ordinary tax rate on both your federal & state tax returns (we will use Ohio in this example).  Depending on your tax bracket, the additional tax on interest-bearing investments can cut deeply into your returns.

One way to minimize interest tax is to invest in U.S. Obligations (Federal Treasury Bonds, U.S. Savings Bonds, etc) and Municipal Bonds.

What are US Obligations and Municipal Bonds?
U.S. Obligations are debt obligations issued by the U.S. federal government and the interest that these U.S. obligations generate is not taxable on your state (OH) income tax return by federal law.  Municipal Bonds are bonds issued by municipalities in the U.S. to complete large projects or to fund cities budgets.  The interest received on municipal bonds is not taxable on your federal tax return and if the municipality that issued the bond is in Ohio, the interest is not taxable on your Ohio tax return.

After factoring in the reduction of tax on interest earned in these types of investment vehicles, bonds of this nature can become quite attractive because of the rate of return plus the tax-free bonus they provide.  However, they are not for all taxpayers, and the decision should not only be based on your tax bracket (see chart below), but should be a part of your overall investment strategy after careful consideration with your investment adviser.  These types of investments are usually not suitable in retirement accounts because of their tax deferred status.

Your federal income tax bracket: Is a municipal bond fund appropriate?
15% Unlikely
25% Likely
28% Very Likely
33% Highly Likely
35% Highly Likely

For example:  If you are in a federal tax bracket of 33% and an Ohio tax bracket of 6% and could find an Ohio Municipal Bond that offered a 3% interest rate, it would be equivalent to a fully taxable investment that yields a 4.91% interest rate.

Want the math?

.33 + .06 = .39

.39 – 1 = .61

3/.61 = 4.91

Or you could just Google—Interest rate calculators

Should you have any questions about the tax implications on bonds or other types of investments please don’t hesitate to give us a call.

As always, you can contact us in Dayton at 937-436-3133 and in Xenia at 937-372-3504. Or visit our web site.

Lance Bradstreet – author of this week’s TTW
Rick Prewitt – the guy behind TTW

…until next week.

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