There’s one readily available and legal source
of untaxed income that we know of: municipal
bonds. These securities are issued by state
and local governments, school districts, hospitals
and other public agencies to support community
projects and services. To permit these worthy
endeavors to raise money economically, Uncle
Sam exempts the interest that they pay from
federal income tax. And state governments usually
do the same for bonds issued within their borders.
As a result, these tax-advantaged “munis” only
pay about 75%-90% of the interest that you’d
earn on a taxable bond of comparable maturity
and credit quality. So, depending on your tax
bracket, munis actually may give you higher
after-tax income. To figure the equivalent taxable
yield of a tax-free bond, divide its yield by
one minus your tax rate expressed as a decimal.
Thus, if your tax bracket for 2006 is 35%, a
5% tax-free yield would be worth 5% divided
by 0.65, or 7.69%.
If you live in a high-tax state, this advantage
can be even more dramatic. Suppose that you
pay an 8% state tax. Because you deduct state
tax from your federal income, your effective
state tax is 5.20% (8% x .65), and your combined
tax rate is 40.20%. So you’d divide that 5%
by .598 (1-.402) and get 8.36%. In that case,
you’d prefer the 5% muni issued in your state
to any comparable taxable bond paying less than
8.36%. The table at the end of this article
shows taxable-equivalent yields for each 2006
federal tax bracket. Obviously, the higher your
tax bracket, the larger the benefit of tax-advantaged
investments.
Types of municipal bonds
According to their issuers and their terms,
munis fall into several distinct categories.
General obligation bonds are backed by the
full taxing power of the city or state that
issues them.
Revenue bonds pay their coupons and repay their
principal from the revenues of the projects
that they fund, which can be toll bridges, airports
or other public facility.
Private activity bonds are issued in support
of private projects, such as industrial parks
or shopping malls, intended to bring business
to the community. Although income from these
bonds issued after August 1, 1986, is exempt
from income tax, it is hit by the alternative
minimum tax when earned by investors subject
to the AMT. This threat tends to push the yields
of these bonds up a bit, boosting their attraction
for investors not affected by the AMT.
Zero-coupon municipal bonds are sold at a large
discount from their face value and pay no current
interest. The investor instead receives the
full face value at maturity, with all the gain
tax free.
Prerefunded bonds. With the relatively low
interest rates of the last few years, some municipalities
have issued bonds to pay for the redemption
of older, higher-yielding bonds on their call
date. Until that time the money is usually parked
in U.S. Treasury securities. As a result, the
prerefunded older munis carry an extra measure
of safety.
Risk management
As with other fixed-income securities, munis
are subject to two distinct types of risk:
Interest rate risk refers to the fact that a
bond loses value in the secondary market when
interest rates rise. Nobody will pay full price
for a 5% bond when new bonds are available that
pay 6%. So, if you need to sell a bond in that
situation, you’ll have to accept a price that
will give the buyer a competitive yield.
On the other hand, if interest rates fall,
the value of your bonds will rise. Don’t count
your chickens, though. Most munis carry call
provisions allowing the issuer to redeem the
bonds early at a specified date, usually with
the payment of a call premium. Note that any
loss that you take on the sale of a muni may
be used to offset capital gains plus up to $3,000
of ordinary income. Any gain, however, may be
subject to ordinary income tax (not the reduced
capital gains rate).
Of course, if you hold a bond to maturity,
interest rate risk is not an issue. Credit risk
refers to the possibility that the issuer will
default on the timely payment of interest and/or
principal. Albeit a rare occurrence, we had
the 1994 example of Orange County, California,
to impress this possibility upon us. Naturally,
lower-rated issues carry higher yields, but
of late the spread between high-quality and
junk bonds has been little more than 1%. So
it’s hardly worth accepting the extra risk for
the marginal boost in income.
As mentioned above, pre-refunding can enhance
the safety of a bond. More common, however,
is the use of insurance to upgrade an issue’s
quality. Issuers purchase private insurance
that guarantees payment of interest and principal
in the event of a default. Bonds thus covered
automatically gain an S&P rating of AAA.
Another way to protect a tax-advantaged portfolio
is diversification. Bonds of different types,
from widespread issuers, and of varying maturities
cushion the effect of trouble in any one sector.
Because most munis are issued in multiples of
$5,000 or $25,000, such diversification is not
possible for most individual investors. For
a tax-advantaged portfolio of less than $500,000
or so, experts recommend investing in either
tax-advantaged money managers or unit investment
trusts.
If tax-advantaged income at the
yields available currently fits your financial
needs, we’re ready to help you build a working
portfolio.
The opinions voiced in this material are for
general information only and are not intended
to provide specific advice or recommendations
for any individual. To determine which investment(s)
may be appropriate for you, consult your financial
advisor prior to investing.
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