Clearing some questions about tax-free bonds

Two concerns appear to cloud the safety of tax-free bonds: (1) The federal government's announced decision to reduce income sharing will affect the incomes of cities and states.

(2) Examples of cities' inability to live within their incomes have been well publicized. New York City was the first, followed by Cleveland. A few others may be close to the brink.

While both of these concerns are valid, municipal bonds react to the same risk/reward formulas as other investments. During these times of concern about the viability of states, cities, and taxing districts, bond prices are pressured downward and yields have boomed. Recently a Washington Public Power Supply System bond issue of $750 million was oversubscribed at a tax-free return of 15 percent. Thus, there are opportunities for the yield-conscious investor willing to assume some level of risk. If you are interested in 10, 11, 12 - possibly up to 15 - percent returns that, at a 50 percent marginal tax rate, are equivalent to 20, 22, 24 and 50 percent, respectively, be aware of these cautions:

* Major issues of municipal bonds are rated AAA (Aaa) and down, similar to ratings for corporate bonds. Small issues by sewer or school districts may not be rated. Although not foolproof, you can rely on ratings as a guide to risk.

* General obligation (GO) bonds tend to be less risky than revenue bonds.

* Bonds issued by some states with good credit are likely to be priced high because those states' constitutions prohibit selling bonds to finance current spending. These states (and many cities) will not succumb to the New York City practice of piling up debts to pay for current spending and the resulting pyramiding of interest. Although some cities may be in trouble financially, many more are continuing to exert effective money management.

* Generally avoid high-interest, long-term bonds selling near par. As interest rates fall, these could easily escalate in price to a level near to or at the call price - the price where the issuer can buy back the bond whether or not its maturity date has been reached. Such bonds could be called in at the call price or their price rise may be restrained by a call provision. Highly discounted issues will likely offer both high current yield and a good chance for appreciation without the call problem.

* If picking individual issues seems risky, look to mutual funds and unit trusts for professional guidance and shared risks. Some of the unit trusts being offered currently are yielding over 12 percent tax free. Mutual funds are generally offering lower tax-free yields, but many are available as no-load mutual funds. Unit trusts generally carry a front-end load of about 41/4 percent. Unit trusts are not managed. That is, unit trusts consist of many municipal bond issues collected into a trust with shares sold to investors. When a specific issue of bonds matures, the principal is returned to investors rather then reinvested. While there is no tax on either the interest or return of capital, you will need to reinvest the capital if you prefer to spend only the income. Tax-free mutual funds offer continuing management with professionals shifting the portfolio of bonds as necessary to keep interest income flowing.

You should be aware that although interest from municipal bonds is free of federal income taxes, income may be subject to state and/or local levies. If you buy a unit trust or mutual fund shares, at least be aware of any state or local tax liability. Individual issues may easily be screened for state and local tax exemption. Earnings limited by risks

My wife and I are over 60. Our only savings of $40,000 are in a bank and earning $500 a month, which does not meet our expenses. We have no other income. Please advise best and safest investment for future to take best advantage of $ 40,000. - H. K.

Yours is a difficult situation where you have few alternatives. Your $40,000 is now earning 15 percent ($6,000 annually) in an insured account. Even if this income is not sufficient for your needs, I would not advise switching it into some other investment, as the added return would not be worth the added risk. At your age you cannot afford to risk losing your capital, because you would not be able to replace it. You have three options: (1) Either you or your wife might consider working full or part-time to increase income to meet your needs. (2) You could restructure spending to live within your available income. (3) You could spend portions of your capital to increase spendable dollars. However, this last action will deplete your capital. For example, increasing monthly takeout to $622.40 rather than $500 would deplete your capital within 10 years. Railroad retirement benefits not taxed

Would you please give me an answer as to why railroad retirement benefits are not taxable? - R. R.

You should have little concern about railroad retirement benefits, as they were specifically declared to be nontaxable when the railroad pension system was originally established back in 1935. Railroad employees are covered by their own pension system and do not participate in social security. Thus, railroad retirement and social security benefits escape taxes under the same concept of long-term mandatory programs. These programs differ from civil service pensions and private company retirement plans. Generally, when contributions to a pension plan are deductible by the employing organization, the proceeds are taxed when the employee withdraws or uses the benefits. E-bond interest

Is the accumulated interest on my E-bonds that will mature next year subject to state sales tax? Your previous article mentioned that over 40 years the redemption value of E-bonds had increased by 389 percent. I do not consider that I made a ''tidy profit,'' on account of the low rate of interest and the taxes I will now have to pay. I may have been patriotic, but it was no bargain. - G. D.

Interest accumulated on your E-bonds is not subject to any state or local taxes. Over the 40 years you will have held your E-bonds for the 389 percent increase in value, the annualized interest averages 3.43 percent.