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Try tax-exempt bonds for emergency
fund
Dear Money Matters,
Would a short or intermediate tax-exempt bond fund be a good place
to have money for an emergency fund for an investor in the 28-percent
tax bracket?
Gregory
Dear Gregory,
First off, props to you for having the foresight to create an emergency
fund. It's something that many investors -- including some who are
rather financially savvy otherwise -- overlook, but it's essential
to put at least three to six months' worth of living expenses away.
That way, should the unforeseen happen -- a car accident, perhaps
the loss of a job -- you still have enough money to see you through
the first few months.
Your question is actually a central point of debate
in many financial circles. Put another way, is it better to take
taxes into consideration when choosing an investment or are you
better off finding the best investments and letting taxes take their
own course?
In your case, you provide part of the answer by saying
you're in the 28-percent tax bracket. In turn, we plug that information
into a simple formula to determine how a tax-free return compares
with one that is taxed.
First, we find the going return of the investment
in which you're interested. I found one intermediate tax-exempt
bond fund that returned 9.6 percent in 2000 and 5.3 percent the
following year.
From there, all we have to do is take that return
and divide it by one minus your tax bracket. I'll show you what
I mean -- in the case of the 9.6 percent return, the formula returns
13.3 percent (that's 9.6 divided by .72). That means the equivalent
taxed return would be more than 13 percent -- not bad at all. Similarly,
5.3 percent tax-free comes out to 7.36 percent -- not as good, but
still nothing to dismiss entirely.
So, on the surface, I would think that a tax-free
bond fund in your bracket makes good sense. Another thing to consider
is local and state taxes. Depending on where you live, some tax-free
bond funds are exempt from state and municipal taxes as well. The
primary downside is that bond funds -- like most any other kind
of investment -- are not ironclad winners (for instance, the fund
I mentioned above lost 1 percent in 1999).
If you don't mind a bit of volatility, then these
funds may be a suitable place to stash your emergency cash. Others,
however, don't want to put their emergency funds in any sort of
danger and opt for safer, but lower-paying returns such as money
market accounts. It all depends on what you're willing to put on
the line in exchange for a potentially larger payoff.
-- Posted: March 27, 2002
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