Tax-Free Investing

It happens every spring: You look at your investment returns. Then you look at your taxes. And if you’re like most investors, you wonder whether there isn’t some way to keep more of what you earn.

Taxes can reduce your investment returns by up to 35%. But it’s worse than that. The impact of taxes actually increases over time because it’s not simply the tax you pay on each dollar you earn. It’s the dollars lost to future compounding that can have a crippling effect on your long-term returns.

Tax-free funds

What can you do to take the bite out of taxes? For starters, take advantage of every opportunity to invest in a retirement plan or account that allows you to defer taxes until you withdraw money. One investment lets you go a step further and pocket your earnings free of taxes: a mutual fund that invests in the bonds of state and local governments and agencies to fund projects such as schools, public hospitals and water districts. Municipal bond funds typically yield less than taxable bonds. But because the income they earn is exempt from federal income tax, they can generate a higher taxable-equivalent yield for investors in higher income-tax brackets.

Easy to figure

Here’s how you figure a fund’s taxable equivalent yield.

1. Subtract your marginal income tax rate from 1.0
For example, (1.0 - .35) = .65

2. Divide the tax-free yield by the product of #1.
For example 3.0 ÷ 0.65

3. The result is the taxable equivalent yield
For example, 4.6%

That’s the yield that a taxable fund would have to earn to equal the yield on the tax-free fund.

Some municipal securities are subject to the Alternative Minimum Tax (AMT), a tax system created to ensure that wealthy individuals pay a minimal level income tax. It’s a good idea to check a fund’s investment policy to make sure you’re getting the tax protection you need. If the securities in a tax exempt fund appreciate in value, the capital appreciation is subject to taxes.

Keep in mind that taxes change, and there’s no guarantee that today’s tax rates will prevail over the long term. But if you want to investigate whether there are tax savings that belong in your pocket, take time to discuss tax-exempt investing with your financial professional.