Get our free newsletter Enter your E-Mail: Can't find it? Search for it: FINANCIAL ARTICLES Investing strategies that can cut your taxes by Jeff Schnepper Typically, when you make a profit on an investment, you have to pay taxes, right? Not necessarily. Let's look at investments that offer tax-free income. Congress has decreed that certain income, either for constitutional reasons or simply for political expediency, is immune from taxation. That's the kind of income you want. Tax-free bonds The first and most well-known tax-free income comes from what are known as municipal bonds. You can exclude from gross income all interest earned on obligations of a state, territory, municipality, or any subdivision. (An exception is the case of arbitrage bonds issued after Oct. 9, 1969.) The idea behind this was to entice investors to purchase these government bonds. After all, you're in essence loaning these governments your money. By being tax-free, governments can entice investors with relatively low interest rates. In return, you get income that's never touched by Uncle Sam. If you're in a sufficiently high tax bracket, the advantages of purchasing a state or municipal bond can be substantial. Let's say you're in the 30% bracket in 2002 and 2003. A 6.5% yield on a municipal obligation is the equivalent of a 9.29% yield on a nonexempt security. Moreover, the risk factor on a state or municipal obligation will normally be lower than that on an industrial security. The higher the tax bracket, the greater the attraction of a tax-exempt security. The following table shows the tax-exempt equivalent yield to a taxable investment at various marginal tax rates:  Tax-exempt equivalent yields Marginal Tax Rate  4% Tax-Exempt Yield   5%Tax-Exempt Yield   6%Tax-Exempt Yield   6.5%Tax-Exempt Yield   7%Tax-Exempt Yield   7.5%Tax-Exempt Yield  10 % 4.44 5.56 6.67 7.78 8.33 4.44 15 % 4.71 5.88 7.06 8.24 8.82 4.71 27 % 5.48 6.85 8.22 9.59 10.27 5.48 30 % 5.71 7.14 8.57 10.00 10.71 5.71 35 % 6.15 7.69 9.23 10.77 11.54 6.15 38.6 % 6.51 8.14 9.77 11.40 12.21 6.51 For example, at a 30% marginal tax rate, you would need to earn 8.57% in taxable interest to have the same after-tax return as a 6% tax-free bond. The savings don't necessarily stop there. Don't forget your local state taxes if the bond you purchased is from your own state. Thus, a New Jersey tax-free municipal bond held by a New Jersey investor would be exempt both on the federal and the New Jersey tax returns. A New York tax-free municipal bond held by a resident of New York City escapes federal, state and city taxation. Savings bonds Another way to get tax-free income is with the special U.S. Savings Bond exclusion. You can potentially exclude all or a portion of the interest that accrues on such bonds if you: Pay qualified higher education expenses in the year of redemption; Are not married and filing separately, and Do not have income over a certain amount. The maximum income you can generate and still qualify for the full deduction is $86,400 for joint returns and $57,600 for all other returns. The interest exclusion is phased out as your income rises, with no exemptions for couples whose joint income tops $116,400 and for individuals with income of $72,600 or higher. The bond must be in your name, not in the name of your child, and had to be bought by you, not a relative or friend. Once your child is in college, you can't claim an exemption for any bonds that exceed the cost of the education. For example, if that year's educational costs total $25,000, that's the maximum amount you can cash in and declare exempt for taxes. To make the numbers simple, assume you redeem qualified bonds with $10,000 in accrued interest. If you're in the 27% bracket, you will save $2,700 in taxes that will therefore become available for other needs. Isn't tax free income fun!!? Tax-free retirement Let’s not forget the Roth IRA, created in the Taxpayer Relief Act of 1997. With the traditional IRA, you get a current deduction and tax-deferred accumulations, and you pay the tax when you withdraw the dollars in retirement. With a Roth, you get no immediate deduction, but all subsequent withdrawals -- both income and principal -- are tax-free. If you have a long-term investment horizon or don't expect your marginal tax rate to be lower at retirement than it is now, the Roth is a good deal. Tax-free alternatives If you're collecting Social Security, there's another wrinkle you should be aware of before you invest in tax-free bonds. Your Social Security payments, potentially nontaxable, become partially taxable depending on the magnitude of your income. If your income is high enough, as much as 85% of your Social Security receipts may be subject to tax. In computing your income, the Internal Revenue Service counts your tax-free income. While the tax-free income itself retains its tax-free status, it may convert non-taxable Social Security receipts into taxable income. Because of this tax impact, many people on Social Security have chosen to invest in tax-deferred instruments rather than tax-free. For example, income earned on a tax-deferred annuity doesn't count in your Social Security computation until it's withdrawn. It therefore doesn't increase the taxability of your Social Security receipts. If you're on the cusp of getting taxed for your Social Security receipts, switching from tax-free to tax-deferred will save you taxes. The price you pay, however, is that these tax-deferred dollars are taxed when withdrawn. Whenever you invest, you must measure your returns on an after-tax basis. Always keep in mind, it's not what you make that counts, it's what you get to keep. With tax-free income, on an after-tax basis, even with a lower yield you may be able to keep more.