Tax-free income in 'munis'

Spring has sprung, and so has the tax season. Wouldn't it be nice NOT to have a tax bill due this month?

If you'd like to earn some tax-free income, consider investing in "munis," or municipal bonds as they are more formally known. The bond issuer borrows the money from you the investor and issues a bond, or a promise, to pay you back your principal plus interest.

While municipal bonds are issued by cities, they also may be issued by counties, states, school districts, airports, hospitals or any other entity funded by local tax dollars.

Munis offer interest rates that are usually lower than the rates you could earn from other fixed-income investments, such as certificates of deposit or corporate bonds.

So why would you want to invest in a muni bond that pays a lower interest rate? The income is tax-free, and the interest you earn from the bank isn't.

To see if it is smarter to invest in a tax-free muni or invest in something that is taxable, you need to do a little math.

The higher your tax bracket, the better it may be to invest in the muni. Let's say the city of Taxville offers to pay 4 percent interest tax-free. XYZ Corp., though, offers 6 percent interest, with the tax bite.

You want to invest $10,000. Which option is better?

You will earn $400 from the city of Taxville. All of it goes into your pocket.

You will earn $600 from XYZ, but if you are in the highest federal and state tax bracket, you will pay about $250 in taxes, leaving only $350 after taxes.

Generally, the interest income you earn from municipal bonds is free from federal taxes. If you are a California resident and choose to invest in a bond issued by the state or any other government entity within state borders, then the interest income is also going to be free from California taxes, in almost all cases.

Not all cities, counties or states are equal when it comes to risk. Just like you and me, they have credit scores, known as credit ratings. The three big rating firms are Standard and Poor's, Moody's and Fitch.

The best rating is AAA. It is followed by AA, then A and finally BBB. Anything below BBB is a junk bond. The higher the credit rating, the lower the risk of default. The lower the credit rating, the higher the interest will be to attract investors.

You must decide whether you want to earn more by taking greater risk or settle for a lower return but greater security.

Finally, when we talk about tax-free income, we are talking about the interest you earn -- not any gains made by selling your bond at a profit. If you bought a municipal bond for $1,000 and before it matures, you are able to sell it for $1,200, you will have a taxable capital gain.

As attractive as it may sound to have all of your income tax-free, municipal bonds should be considered only as part of a diversified portfolio and only if your tax bracket is high enough to make it a benefit. Then next April, you can smile about the income that goes 100 percent to you.

About the writer:
Tom Sullivan, managing director of the Sullivan Group of Wachovia Securities in Sacramento, provides financial commentary for radio station KFBK (1530 AM) and NBC-TV affiliate KCRA. If you wish to comment on Tom's column, send e-mails to sacbiz@sacbee.com.