Would you be closer to achieving your financial goals if you weren’t paying taxes on investment income? Imagine how much faster you could accumulate wealth if more of your investment return was retained to compound over time without federal taxation.
The difference between a tax-free investment and a taxable investment can be substantial. The accompanying graph shows how $10,000 grows when allowed to compound without federal taxation.
The graph assumes $10,000 of principal is invested at a nominal annual rate of 6.5% compounded monthly. This rate is for illustrative purposes only and does not take investment risk into consideration. Current, available rates may vary substantially from this illustration, as well. It is also assumed that the investor pays annual federal income tax at a rate of 31% on the total amount of interest credited to the account.
One way to achieve tax-free income with minimal risk may be through municipal bonds or municipal bond mutual funds. Tax-exempt bond fund investors are immediately diversified. Portfolio managers make gains through trading, and depending on the fund, avoid bonds that may be too volatile. The chief appeal is that municipal bond interest, with modest exceptions, is exempt from federal taxation. Some states and cities also make interest on their own obligations exempt from taxation. When buying municipal bonds or municipal bond funds, keep in mind that investment returns and principal values will fluctuate due to market conditions so that shares, when redeemed, may be worth more or less than their original cost.
As a consequence of their privileged tax status, municipal bonds may provide lower interest rates than fully taxed bonds, to which their interest rates are often measured and compared. Municipal bonds may be advisable for investors who occupy higher tax brackets, although even those in a lower tax bracket may potentially benefit from municipal bond funds.
Quality and call provisions are very important when buying municipals. Although the threat of default by some cities and public power suppliers has made news from time to time in the past, investment-grade municipals may be considered relatively secure from default. Tax-exempt bond funds reduce the administrative time required to make decisions about individual municipalities and call provisions.
Time spent determining your investment aims and working with your financial professional can help you decide which fund is best for you.