MONEY TALK / CARLA LAZZARESCHI : Tax-Free Bonds Aren’t for Everyone

Q: Ads promoting various municipal bond funds always stress the high taxable return an investor would have to receive to equal the considerably lower rate paid by the fund. But then, in tiny print, the ads explain that to get these enticing returns, an investor must be in a high combined state and federal tax bracket, which lots of interested investors simply are not.

Is there any simple way for investors to figure out when it is smart for them to invest in these tax-free bond funds? --R.E.D.

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A: Tax-free investments make the most sense for high-income investors because they are avoiding the maximum possible tax bite on their interest earnings. A little bit of math can prove the point, as the following calculations show. Readers wanting to evaluate the wisdom of purchasing tax-free investments can customize the formula by supplying their own personal tax data.

First, we’ll look at Married Couple No. 1 whose marginal federal tax rate is 28%. The couple is considering investing in a federal tax-free mutual fund yielding 5%. To compute the equivalent taxable return, divide the tax-exempt yield (5%) by 1, minus your marginal tax rate expressed as a decimal (1-.28=.72). The answer is 6.94%, meaning that the couple would have to earn a taxable yield of 6.94% to match the 5% tax-free yield. However, Married Couple Couple No. 2 is in the 15% tax bracket. For them, the return from a 5% tax-free investment equals the return from a taxable investment yielding 5.8%.

It is almost as easy to make similar comparisons with double tax-free investments, such as state or local government bonds.

First, you must calculate your combined effective federal and state tax rates. Start by multiplying your state tax rate--9.3% for Couple No. 1--by 1 minus your federal rate expressed as a decimal, or .72 for this couple. The answer here is 6.696. Now add that to your federal rate, 28% for this couple, for a combined rate of 34.696%. Subtract that number from 1. The answer is 65.304%, or, expressed as a decimal, .65304. Now divide the tax-free yield--we’ll say it’s 5% again--by .65304 and the answer is 7.65%. This means that Couple No. 1, with a combined effective tax rate of 34.696%, would have to earn a taxable yield of 7.65% to equal the return of a double tax-free investment yielding 5%.

The combined effective tax rate for Couple No. 2, which is in the 15% federal tax bracket and the 4% state bracket, is 18.4%. To calculate the taxable equivalent yield to 5% tax-free yield, we’ll divide the 5% by .816. The taxable equivalent return is 6.12%--a full one-fifth less than the equivalent rate flowing to Couple No. 1.

Social Security at Age 60 for Widows

Q: I am a 57-year-old widow and am eligible for my own Social Security benefits at retirement. I have been a widow for the last 22 years. I am contemplating retiring at age 60 and understand that I would be eligible to begin receiving widow’s benefits at that age. By what percentage would those benefits be reduced since I will be less than age 65? If I start on widow’s benefits, may I switch to my own benefits at age 65? --M.R.

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A: Widows, and only widows, are entitled to begin drawing Social Security benefits at age 60. However, by electing to start benefits before turning age 65, you face less than the full 100% of your widow’s benefits. At age 60, widows are entitled to 71.5% of the deceased’s benefits. However, at age 65 you may switch to your own Social Security benefits for the remainder of your life. At this age, you will receive nearly 100% of your total benefits; a small amount will be deducted because you started to draw benefits at age 60.

Although you should check with your local Social Security office to be absolutely sure of what you are entitled to, it would appear that your decision to draw on your late husband’s account before turning to yours is a wise one. Because your husband has been dead for such a long time, his qualifying wages are considerably lower than they would be if he had been in the work force longer. As a result, your widow’s benefits are likely to be lower than what you are entitled to receive on your own account.

Because Social Security benefits for spouses, widows and divorced spouses generate a large volume of mail to the column, we offer our special Money Talk pamphlet with the answers to the 20 most frequently asked questions. The booklet, “Social Security Benefits,” costs $4 plus 33 cents tax. It is available only by mail by sending a check for $4.33--made payable to the Los Angeles Times--to Los Angeles Times Social Security Booklet, P.O. Box 60395, Los Angeles, Calif. 90053. Allow three to four weeks for delivery.

Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Please do not telephone. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.

A Taxing Question

Tax-free investments offer the best deal for taxpayers in the highest brackets because these investors are able to shelter the greatest amount of income. Here is a list of various taxpayer incomes, their combined state and federal tax bracket and what yield they would have to earn on a taxable investment to get the equivalent of a 5% tax-free yield.

Married/ Tax Taxable jt. return Single brckt. yield $20,000 $10,000 17% 6.00% $25,000 $17,000 18% 6.12% $35,000 $20,000 20% 6.25% $37,500 $22,500 32% 7.38% $50,000 $25,000 34% 7.54% $75,000 $50,000 34% 7.65% $100,000 $75,000 37% 7.98% $150,000 $115,000 38% 8.05%

Source: Lebenthal & Co.