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Gro w Y our Retirement Nest Egg

• You do not plan to make modest additional investments.
• You plan to hold your bonds to maturity.

Municipal bonds or bond funds can be attractive income investments
because interest is exempt from federal tax, and usually from state and local
taxes, if the buyer lives in the state issuing the bonds. These bonds are partic-
ularly appealing to investors in high tax brackets who live in high-tax states.
Municipal bonds pay lower yields, but if you pay federal, state, and/or

local taxes on the interest from taxable bonds, you may find that municipals
actually generate more net interest income for you than taxable bonds with a
higher stated yield. Why? The tax bite on taxable bonds is often greater than
the advantage of apparent yields compared with tax-free bonds. Your tax
bracket dictates whether tax-exempt investments will give you a higher after-
tax yield than fully taxable investments will.
Compare taxable versus tax-free yields with the following formula:

Tax-free yield

Taxable-equivalent yield _________________________________

1 Your federal and state tax bracket

The tax-equivalent yield will be higher for investors in the higher tax
brackets. Suppose the yield on a tax-free bond or fund is 4 percent, while the
yield on a taxable vehicle is 5 percent, and your federal tax bracket is 28 percent.
So 4 percent divided by 0.72 (1 minus 0.28) equals 5.55 percent, which means
the municipal investment gives you the higher net yield. If you also pay state
income tax at 5 percent, the calculation is 4 percent divided by 0.67 (1 minus
0.33; 28 percent plus 5 percent), which equals a 5.97 percent taxable-equivalent
yield.
Here’s a quick guide to help you determine if a municipal bond or fund is
suitable for you:
Federal tax bracket Whether appropriate
15 percent Unlikely
25 percent Maybe
28 percent Probably
33 percent Very likely
35 percent Very likely

For other types of bonds, such as mortgage and corporate securities,
mutual funds generally are your best bet because these types of bond funds
often have different characteristics and require extensive analysis.

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