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Scott Burns / Syndicated columnist
Tax-free investing often doesn't work

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J.H., Dallas

A: There are two important questions to answer before you make a tax-free investment.

The first is simple. Will the tax-free interest income you receive be greater than the after-tax income you'll have from a taxable investment of comparable credit risk and maturity?

Years of readers' letters have taught me that most people are tax-phobic. As a result they take more pleasure in not paying taxes than in having more money to spend.

When they do have more income to spend, it is usually because they have increased their risk.

To answer which real income will be greater, you need to know your marginal tax rate. That's the tax rate you pay on your last dollar of income.

A single taxpayer with taxable income of $7,150 to $29,050 is paying income taxes at a marginal rate of 15 percent.

If they can get a yield of 4 percent on a tax-free investment, they'll need to get a yield of at least 4.7 percent to receive the same amount of after-tax yield. (To calculate such figures, divide the tax-free yield by 100 minus the marginal tax rate.)

Recently, AAA-rated long-term tax-free bonds were yielding 96 percent of the yield on same-maturity U.S. Treasury obligations. That means an investor in the lowest tax bracket would benefit from tax-free bonds.
 
Unfortunately, shorter-term obligations don't enjoy the same benefit. Tax-free obligations that mature in two years, for instance, were yielding 78.5 percent of same maturity Treasury obligations.

A 15 percent tax-bracket investor would lose purchasing power by choosing short-term tax-free investments.

Retirees collecting Social Security benefits need to answer a second question because tax-free income must be included when determining whether your Social Security benefits are taxable.

Since an additional $1,000 of tax-free interest may trigger the taxation of $500 or $850 of Social Security benefits, adding tax-free income may increase your tax bill.

For many, a better alternative is to buy a life annuity because the monthly income will be higher and most of the income will not be included in the formula for the taxation of Social Security benefits.

Questions about personal finance and investments may be sent to Scott Burns at The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; by fax at 214-977-8776; or by e-mail at scott@scottburns.com. Questions of general interest will be answered in future columns.