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Portfolio or Investment Income consists primarily of interest and dividends and gains generated from the sale of stock. Portfolio income is income generated by an activity that is not considered a trade or business.
Tax-exempt state and local bonds are a significant way to reduce taxable income. The interest earned on most state and local bonds will be exempt from both federal and state income tax if bonds are purchased from the resident state. The yields on state and local bonds will generally be lower than the yields from corporate bonds and other investments. But you need to compare the net cash flow after taxes.
|$1,000 investment interest per year|
Pointer: Before investing in any state or local bond, check out the tax-exempt status of the bond, the stability of the issuing local and the bond rating. Bonds are rated based on financial stability from AAA rating the highest to D rating the lowest. If you are a conservative investor, look for the highest rated bonds.
Federal obligations such as Treasury Bills, Treasury Notes and Treasury Bonds will yield a better interest rate than the exempt state and local bonds. Interest income is generally tax free at the state level but taxed by the federal government. The difference between the various Treasury instruments is the length of time to maturity.
Treasury Bills 3 , 6, or 12 months
Treasury Notes 2-10 years
Treasury Bonds 10-30 years
The purchase of certain federal government obligations can result in a deferment of taxes. For example, interest on a Treasury Bill with a maturity date on one year or less is taxed only at maturity. Therefore, the interest on a 6 month bill purchased in October of 1999 will not be taxed until the year 2000. Also, the interest on the Series EE bonds is not taxed until the bond is cashed unless the taxpayer elects to report the interest each year.
Pointer: Series EE bonds can be used as investment for children under the age of 14 to avoid the Kiddie tax. If the bonds are held and cashed in after the age of 14, the interest will be taxed at the child's rate instead of the parents rate.