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Tax-free CDs

What are tax-free CDs? How do they differ from traditional (taxable) CDs?

Banks don't issue tax-free securities; state and local government agencies issue them. Certificates of deposit, or CDs, are investments issued by banks and other financial institutions. There are no tax-free CDs, just methods of deferring the tax paid on the interest income generated by the certificates.

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I only know of two ways to postpone paying taxes when investing in CDs. The first is to invest offshore and not report the income to the Internal Revenue Service. You postpone paying taxes until the IRS catches up with you. The yield offered on the offshore CDs should be adjusted for any penalties, back interest, legal fees and time spent in jail you may incur.

The other way to defer the taxes is by setting up the CD as an IRA, IRA Rollover, IRA-SEP or other form of tax-deferred retirement account. You pay taxes on the contributions and interest income but not until retirement when you take distributions from the plan. You may pay less in taxes on the distributions if your marginal tax bracket is lower in retirement than it is today.

There are plenty of ways to invest short-term in tax-free securities. The easiest is to buy a tax-free money market mutual fund that invests in municipal securities of your home state. When you buy municipal offerings from your home state, the interest is exempt from both state and federal income taxes.

There's no FDIC insurance behind the investment, as there would be with a CD or bank money market account, but money market mutual funds are very secure investments. The funds also would be more liquid than a certificate of deposit.

Another way to invest tax-free over the short term is by buying individual municipal securities. You can buy new-issue municipal securities in $1,000 increments. Short-term municipal notes will mature in a year or less. Longer-term municipal bonds have final maturities of one to 30 years.

When you buy new issues, the issuer pays the sales commission to the broker. If your brokerage firm doesn't participate in this market it won't be able to offer municipal securities to you free of commission. If you sell a small position before it matures, the transaction costs and selling price will make you wish you had bought the tax-exempt money fund instead.

Investors should determine whether they are subject to the alternative minimum tax, or AMT, prior to investing in municipal securities. You broker will work with you to determine the relative tax advantages of the different municipal securities available to you.

You can compute the taxable equivalent yield by dividing the APY by 1, minus the tax rate. For example, if you are in the 36-percent bracket for federal income taxes, and pay a 5 percent state income tax, the taxable equivalent yield on a municipal offering for your home state priced to yield 4 percent would be 6.78 percent. (6.78% = 4% divided by (100% - (36% + 5%))) Use the tax equivalent yield as a decision tool. Assuming two securities of equal credit risk, if the taxable security yields more than the taxable equivalent yield of the municipal security then you should invest in the taxable security.

Editor's note: The rates in this story are used for comparisons and are NOT actual rates offered today. They are simply examples. For today's CD rates, check Bankrate.com.

Bankrate.com's corrections policy
-- Updated: Nov. 17, 2005
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