A person in the highest federal, state and local tax brackets in New York City loses almost one-half of his investment yield to taxes (source: IFDS Web site, www.ifds.com).

It’s no secret that taxes can eat up a considerable amount of the interest you earn on your investments. So how can you keep more of the interest your investments earn? Tax-free investments may be a good way to lighten your tax burden while further diversifying your portfolio.

Municipal Bonds

A common approach to tax-free investing is the individual municipal bond. These bonds are issued by state or local governments to build roads, airports and hospitals, among other things. Interest earned on municipal bonds isn’t taxable by the federal government. Additionally, if you purchase a bond issued by your municipality or state, it may be free from state and local taxes. Typically, a minimum investment of $5,000 is required, and your tax-free interest is paid semiannually. One of the key advantages of individual municipal bonds is that the interest rates are fixed, so you always know how much you’ll earn.

Tax-free Mutual Funds

If you want to diversify your bond portfolio but don’t want to buy a legion of individual bonds, you can purchase shares in a bond mutual fund. These funds normally invest in 30 to 100 municipal bonds, giving you instant diversification. Also, in most cases, your initial investment can be smaller than $5,000. In addition, tax-free mutual funds pay you monthly income; however, the amount of your payment is not fixed.

Tax-free Unit Investment Trusts

Maybe you’re interested in the instant diversification of a mutual fund, but you’d rather receive a fixed interest rate. Purchasing shares of a unit investment trust would be an option for you. With a unit trust, you get a fixed rate of interest and the added benefit of diversification in seven to 12 tax-free bonds. Plus, tax-free unit trusts pay investors a monthly check. They do, however, generally yield less than individual bonds.

It is important to note that tax-free mutual funds and unit trusts may be subject to the alternative minimum tax as well as state and local taxes. In addition, the return and principal value of municipal bonds, mutual funds and unit trusts will fluctuate based on current market conditions.

Taxable vs. Tax-free

Because of the tax advantage they offer, tax-free investments often provide significantly more after-tax income than comparable taxable investments paying higher interest rates. The chart below compares the taxable yields necessary to match the return on tax-free bonds after payment of federal income tax.
(This example does not represent current available rates.)

   You may not want to overlook the benefits of tax-free investing. If you want to free yourself from taxes, remember, you have three ways to save: municipal bonds, tax-free mutual funds and tax-free unit investment trusts.