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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.
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.
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