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Publication: Investor's Notebook
TAX-FREE BOND INCOME MAY NOT ESCAPE TAXES

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       Investor's Insight - Friday, January 27, 2006           
          "A Digest of Investment Opinion From the 
             World's Leading Financial Advisers"


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Comment The Post Below...


TAX-FREE BOND INCOME MAY NOT ESCAPE TAXES
by Scott Burns

Q: I'm at a loss to understand how municipal bonds work. 
In January 2003 I was advised to invest in a municipal 
bond fund that specialized in short-term bonds. Now, 
almost three years later, I've barely seen any gains in 
my quarterly reports. Sometimes, the report shows that 
I've lost money. Other times, it shows a small gain. Mean-
while, the management firm takes about $1,200 in yearly 
fees.

My financial adviser says this is to be expected because 
none of the bonds have matured this year and because the 
fund keeps shifting its investments. About 5 percent of 
the bonds will mature in less than a year, 33 percent in 
one to two years, and 62 percent in two to five years. 

Is my financial adviser right? Is it just a question of 
"staying the course" and waiting for the bonds to mature, 
or should I get out of this fund as soon as possible? 
-- R.S., by e-mail

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A: Investing short term, whether it was in tax-free or 
taxable bonds, hasn't been a very good play in the last 
three years because the Federal Reserve has been increas-
ing the only interest rates it can change -- short-term 
rates. As a consequence, the net asset value per share 
of short-term bond funds has tended to decline as the 
yield on short-term securities has risen.

As a practical matter, while short-term bond funds have 
performed relatively poorly compared to long- or inter-
mediate-term funds, your adviser was probably trying to 
protect you from the greater damage that can occur to 
long term bonds when (and if) interest rates rise.

Q: My wife and I are retired and debt-free. The three 
sources of our income are our state's teacher retirement 
system, municipal employees' retirement fund and Social 
Security. We are approaching the age of mandatory IRA 
withdrawals. We would like to place these funds where 
we would not have to pay taxes again and begin to draw 
tax-free earnings.

Our thoughts are to build a five- to eight-year municipal 
bond ladder, or to purchase shares in municipal bond funds 
of various maturities. With the bonds we would pay a broker 
mark-up but receive full principal at maturity. With the 
funds, we would pay small fees but lose principal if we 
had to sell at a lower price than our purchased price. 
What do you suggest? -- R.P., Des Plaines, Ill.

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A: To do this right you'll probably need the advice of a 
good tax accountant. It is very likely that you face a tax 
trap. Tax-free bond income is one of the sources of income 
that must be counted when you are figuring whether your 
Social Security benefits are taxable. As a consequence, 
you could have tax-free municipal bond income that would 
still work to increase your federal income tax bill because 
each dollar of interest could trigger the taxation of 50 
cents to 85 cents of Social Security benefits.

If you want to complain about this, direct your complaints 
to the Republican and Democratic parties. The Republicans
put the tax in place. The Democrats increased it.

As an alternative, you may want to try a "Plan B," again 
in consultation with a good tax accountant. If you truly 
want to pay taxes only once, you should look into doing 
a Roth-IRA conversion. You'll pay ordinary income taxes 
on withdrawal, but once the IRA money is in a Roth IRA, 
you'll have complete freedom in making withdrawals. And 
all withdrawals will be tax-free.

Conversion would allow you to earn higher yields in taxable 
securities but avoid taxation on any withdrawals.

Are there any pitfalls? Of course! You can't make with-
drawals from a Roth for five years without paying a penalty. 
That's a good reason to start the Roth conversion now, be-
fore mandatory withdrawals.

(Investor's Insight reflects the opinions of experts. It does 
not recommend any specific investments, and no endorsement is 
implied or should be inferred. For more information, contact 
the individual firms cited).

COPYRIGHT 2005 UNIVERSAL PRESS SYNDICATE

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