What's Best, Tax-Free or Taxable Interest Income?

A frequent taxpayer question is whether it is better to invest for tax-free or taxable interest. Generally, taxable interest will provide a greater return, but this may not hold true after taking into account taxes on the income. Therefore, the question is really which provides the greater "after-tax" return.

Making a decision will take on another layer of complexity for higher-income taxpayers beginning in 2013 when the new surtax called the Unearned Income Medicare Contribution Tax is imposed on the unearned income of individuals, estates, and trusts. For individuals, the surtax is 3.8% of the lesser of:

1. The taxpayer’s net investment income, or
2. The excess of modified adjusted gross income over the threshold amount ($250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others).

“Net” investment income is investment income reduced by allowable investment expenses. Investment income includes income from interest, dividends, annuities, royalties, rents (other than those derived from a trade or business), capital gains (other than those derived from a trade or business), trade or business income that is a passive activity with respect to the taxpayer, and trade or business income with respect to the trading of financial instruments or commodities. For surtax purposes, modified adjusted gross income does not include excluded items, such as interest on tax-exempt bonds, veterans' benefits, and excluded gains from the sale of a principal residence.

To avoid or minimize this new tax, higher-income taxpayers may wish to alter their investment portfolios to include more of the non-taxable investments described below.

There are basically four types of interest that can be excluded from income, either on the federal return or the state return, and each has its own special considerations.

Municipal Bond Interest – Interest earned from general-purpose obligations of states and local governments, which are issued to finance their operations, are generally tax-exempt for federal purposes. However, the various states usually only exempt interest from bonds issued by the state itself and local governments within the state. Hence, there are two categories of municipal bonds: the tax-free federal and state and the tax-free federal only. Individuals can invest in municipal bonds by directly purchasing a bond or through mutual funds that invest in municipal bonds. Some mutual funds invest in bonds issued only in a particular state, providing residents of that state with income that is excludable on their state returns as well as their federal returns.

For those drawing Social Security, you must also keep in mind that, even though the income itself is tax-free, it is included in the computation used to determine how much of your Social Security income is taxable.

Private Activity Bond Interest – Some municipal bonds, classified as Private Activity Bonds, are tax-free for the purposes of the regular federal tax but may be taxable for the purposes of the federal Alternative Minimum Tax (AMT). If a taxpayer is subject to the AMT, then the interest from these bonds may be taxable to some extent. The actual rate will depend upon your filing status and other AMT income but could be as high as 28% plus any state tax, if applicable.

U.S. Government Bond Interest – Under federal law, direct obligations of the U.S. government cannot be taxed by the states. This includes interest from U.S. savings bonds, U.S. Treasury bills, notes, bonds, or other obligations of the United States. Interest earned from the Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (Ginnie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC) are not direct obligations of the U.S. government and, therefore, are not excludable from state taxation unless specifically allowed by state law, which is generally not the case. If you reside in a state with no state income tax, U.S. government bond interest provides no tax benefit.

If you do have a state income tax and the investment is tax-free in your state, then it also makes a difference whether or not you itemize your deductions on your federal return. Since having state tax-free income reduces your state tax, which is deductible if you itemize, the reduced state tax, in effect, reduces your itemized deductions and increases your federal tax.

If you have questions related to tax-free investment income or how the new surtax on investment income might impact you, please give our office a call.