A simple and perfectly legal way to avoid any Federal income tax on investments is to choose bonds. The U.S. government does not tax the interest paid on bonds issued by state governments or any of their subsidiaries.
Superficially, the idea of owning tax-exempt bonds naturally sounds fine, and the higher a man's income-tax bracket, the more important it sounds. But unless a man has considerable capital, the first snag in putting the idea into action is that none of these bonds is sold in a manner making it really practical to own them.
Some mutual-fund sponsors have been attempting to obtain tax exemption for an individual on dividends received from a mutual fund whose portfolio is invested entirely in tax-exempt bonds. If this plan becomes legal, a man can obtain a tax-exempt investment by merely buying shares of one of these "exempt-bond" mutual funds and, as in other mutual funds, gaining the advantages of a large pool of capital, diversification, and skill in selection of bonds by the fund managers.
This plan is not a tax dodge, for an individual shareholder in one of these funds would be in the same tax position as if he bought tax-exempt bonds direct From a broad social viewpoint, it is easy to find reasons why there should be no tax-exempt bonds; but as long as the law allows them, in large and growing quantities, why shouldn't they be made practically available to an investor with little capital?
At present we suggest that before buying bonds to obtain tax exemption, an investor should make sure he understands the A B C's of the bond market. The price of a bond depends more on the number of years to maturity, the credit standing of the borrower, and other technical points than on whether the bond is tax-exempt. We suspect that the advantage of tax-exempts is generally overrated by people who are influenced more by words than by study of net dollar results with these bonds, as compared to other possible investments.
Some investments, although not labeled tax-exempt, may cause far less income-tax liability than others do. On an E bond issued by the U. S. government, income takes the form of a semi-annual rise in the value of the bond. The government pays this income only when a bond is cashed, and a bond-owner can elect to wait for this cashing before he pays income tax. So the tax to be paid on an E bond is something of a gamble, depending on when the bond is cashed. On E bonds issued before February 1957, the government extended the original maturity by ten years, making a total of almost twenty years that a bond can be held before any income tax is due. Whether a similar extension will be made on the newer bonds is not clear.
The tax delay on E bonds is especially attractive to a middle-aged man who is paying income tax at a rather high rate. He can buy the bonds now, expecting that before they mature, his retirement from earning an income will cut or eliminate his income tax. Or if he dies, his estate will not have to pay tax on the appreciation accumulated during his lifetime. Thus under some conditions, an E bond can be as free of income tax as a bond labeled tax-exempt. And even though the amount of tax eventually paid on an E bond is the same as if paid each year as the bond's value appreciates, still the mere delay can be an advantage.
It is possible to avoid taxes on your investments, if you do your research and choose wisely -- particularly if you invest heavily in tax-free bonds.