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I was looking into money market funds and bond mutual funds for some relatively stable investments. Before I make decisions, though, can someone explain under what circumstances would I need to pay federal vs state vs municipal tax, and ways of minimizing those taxes?

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Distributions of interest from bonds are taxable as income by the Federal, state and municipal (if applicable) government. End of year fund distributions are subject to capital gains taxes as well.

You can minimize taxation by:

  • Buying tax-exempt obligations of the US Government. (Exempt from Federal, but not usually local taxes)
  • Buying tax-exempt obligations of your state and US territories like Puerto Rico, the US Virgin Islands, and Guam. (Exempt from Federal, State and possible municipal income taxes)
  • Buying tax-exempt obligations of your city. (I know that New York City bonds are exempt from Federal, New York and New York City income tax, not sure about others)

Note that the only bonds that are guaranteed safe are US Government obligations, as the US government has unlimited taxation powers and the ability to print money. Municipal obligations are generally safe, but there is a risk that municipal governments will default.

You can also avoid taxation by not realizing gains. If you buy individual stocks or tax-efficient mutual funds, you will have minimal tax liability until you sell.

Also, just wanted to point out that bonds do not equal safety and money markets do not pay sufficient interest to offset inflation, you need a diversified portfolio. Five year treasury notes are only paying 1.3% now, and bond prices drop when interest rates go up. Given the level of Federal spending and the wind-down of the war, its likely that rates will rise.

  • You can also avoid taxes by investing in a tax sheltered account (401(k), IRA, Roth IRA, HSA, ESA, etc). Of course, some of those will be taxed in retirement (possibly at a better rate) and you can't take money out of them as freely. – fennec Sep 15 '10 at 13:58
  • I don't believe there are any tax-exempt obligations of the US government (with respect to federal taxation). Also, due to the Supremacy Clause of the US Constitution, interest on direct US obligations is exempt from state and local income taxe. – QuantumMechanic Apr 10 '14 at 2:24

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