Tax-free investment surge favors funds in municipal bonds

It's an old game, but last year it was being played by a lot more people. The game might be called Keeping the Tax Man at Bay. More two-income families, higher returns on tax-free investments, and a growing awareness of legitimate ways to cut the tax bite all combined to make 1983 the biggest year yet for tax-free investments. Tax-exempt money market funds, municipal bonds, insured bond trusts, utility stocks and funds, and tax-deferred annuities gave big investors and ordinary savers a place where they could get returns free of federal taxes.

''More and more families have dual incomes,'' notes Jack Merritt, president of Van Kampen Merritt Inc., a Philadelphia brokerage. ''Coincidentally, tax-exempt bonds are at historically high levels, offering one of the best rates of return.''

One reason rates on these bonds are so high, observers note, is that cash-strapped states and cities are issuing three times as many bonds as they did a decade ago. The institutions that used to be their primary customers - banks, pension funds, and nonprofit organizations - aren't buying as many, however, forcing the municipalities to sell more to individuals, who demand higher returns.

And despite the financial troubles of the Washington Public Power Supply System (WPPSS or ''Whoops''), municipal bond sales have remained strong, even though WPPSS missed its first interest payment earlier this month.

The biggest beneficiary of the boom in tax-free investing is the municipal bond mutual fund. Last year, combined sales of long- and short-term bond funds reached about $54 billion, compared with $32.9 billion in 1982, according to the Investment Company Institute, the mutual fund industry trade organization. In the non-money fund category, ''muni'' funds were second only to aggressive growth funds, which enjoyed the ride on the high-flying stock market.

Part of the reason for increased interest in tax-free investments has been the publicity and promotion of individual retirement accounts (IRAs), which have been available to all wage earners - not just those without a company retirement plan - for two years now. With the US government encouraging one sort of tax-free savings, the financial services industry has been happy to offer other variations on the theme.

In addition to municipal bonds and bond funds, for example, some investment firms have come up with their own particular products for tax-conscious investors and savers.

One such product is designed to protect against what some call the ''hidden'' risk in municipal bonds. Although the interest is supposed to be guaranteed by the issuer, the bonds themselves may decline in value during their life, if interest rates should rise. So if an investor needs to sell a bond before maturity, he or she may lose money on it because other investors would prefer to take the higher yields of more recently issued bonds.

To help protect against this risk, Merrill Lynch & Co. is offering a tax-free bond fund that includes a secondary market where bond units can be quickly sold if their value starts to drop. This is similar to an investor buying and selling stocks, except that the gains are tax-free income, not taxable dividends or capital gains.

One possible drawback to this product, however, is the cost. The Merrill Lynch municipal investment trust pays a tax-free return of about 7 percent, some 2 percent lower than current market rates. But the security of reduced market risk in these days of interest-rate fluctuations may be worth the cost.

To help protect against the kind of worries that WPPSS bondholders have had, a few firms are offering packages of insured bonds. They are not insured by the federal government, but by private consortia funded by insurance companies and brokers. One such product is a tax-free trust sold by Van Kampen Merritt and insured by the American Municipal Bond Assurance Corporation (AMBAC). For Van Kampen, sales of these trusts amounted to more than $2.17 billion in 1983, compared with $1.72 billion in 1982, according to William Molinari, executive vice-president in charge of the unit investment trusts department at Van Kampen.

Again, while AMBAC should protect investors from the risks of default, it cannot protect against market risk. So investors are left with the choice of accepting a lower yield in return for lower market risk, or taking a higher return and the additional income that goes with it, but then having to watch the bond market more closely.

Beyond the various ways to minimize the risk, however, investors have to figure out if they should be in tax-frees at all. True, higher yields on tax-free investments do make them attractive to people in lower brackets than before, but not that low. For married couples in the 33 percent bracket and up (joint income over $35,200 after all deductions), tax-exempts can make sense.

Do not use gross income, however. Someone earning $25,000, for example, might have an after-deduction income of around $20,000. Tax-exempt investments will not work for that person.

To find out if a tax-exempt investment is for you, subtract your after-deduction bracket (35 percent, for example) from 100. The result is 65. Divide the tax-exempt yield (say 9 percent) by 65. The result is 13.8, which is the yield you would have to get on a taxable investment to match the return on the tax-exempt investment.

Finally, check the tax laws in your state. If the bonds are issued by a government in the state where you live, they are probably exempt from state income taxes. If not, you may have to pay ordinary capital gains taxes to your state treasury. Tax-exempt income makes a difference Find your taxable income (after all deductions) and tax bracket. Read down to find what an investor would have to earn to match the tax-exempt yield. Single return $18,200 $23,500 $28,800 $34,100 $41,500 $53,300 $23,500 $28,800 $34,100 $41,500 $55,300 & over

Joint return $24,600 $29,900 $35,200 $45,800 $60,000 $85,600 $109,400 $29,900 $35,200 $45,800 $60,000 $85,600 $109,400 & over

Tax bracket 26% 28% 30% 32% 35% 36% 40% 44% 45% 48% 50%

Tax exempt yield Equivalent taxable yield 4% 5.33 5.56 5.71 5.88 6.15 6.25 6.67 7.14 7.27 7.69 8.00 5 6.67 6.94 7.14 7.35 7.69 7.81 8.33 8.93 9.09 9.62 10.00 6 8.00 8.33 8.57 8.82 9.23 9.38 10.00 10.71 10.91 11.54 12.00 7 9.3 9.72 10.00 10.29 10.77 10.94 11.67 12.50 12.73 13.46 14.00 8 10.67 11.11 11.43 11.76 12.31 12.50 13.33 14.29 14.55 15.38 16.00 9 12.00 12.50 12.86 13.24 13.85 14.06 15.00 16.07 16.36 17.31 18.00 10 13.33 13.89 14.29 14.71 15.38 15.63 16.67 17.86 18.18 19.23 20.00

Example: A married couple with an income of $40,000 would have to find an investment paying 13.85 percent to match a tax-free yield of 9 percent.