by Ken Stelts, Investment Counselor
If you're an investor, 2003 was a pretty good year, from a tax standpoint. The tax laws implemented that year lowered tax brackets and cut the maximum rates on long-term capital gains and stock dividends to 15 percent. Still, for 2005, you may want to do even more to control your investment taxes -- so you might want to consider municipal bonds.
By investing in municipal bonds, also known as “munis” or tax-free bonds, you may be able to achieve significant advantages, particularly if you're in one of the upper tax brackets. When you own a muni, your interest payments will be free from federal taxes, and, if the municipality that issues the bond is located in your state, your interest payments also may be exempt from state and local taxes.
In fact, the tax advantage of municipal bonds may be so great that you'd have to earn a considerably higher interest rate on a taxable bond -- such as a corporate bond -- just to get the same after-tax return. For example, suppose your federal tax bracket is 25 percent, your state income tax rate is 5 percent and you buy a state tax-free municipal bond that pays 4.5 percent interest. You would have to earn 6.32 percent, or higher, on a corporate bond of similar maturity and quality to match the 4.5 percent yield of your muni. This 6.32 percent figure is the municipal bond's “taxable equivalent yield.” And your municipal bond would provide you with an even greater taxable equivalent yield if you were in a higher tax bracket. If you don’t know your federal and state tax brackets, your tax professional should be able to help you determine these important figures.
Munis and the AMT
Municipal bond interest is free from federal taxes, but some munis -- particularly airport and housing bonds -- might be subject to the alternative minimum tax (AMT). If you think you may have to pay the AMT, you might want to avoid these types of bonds. Conversely, if you know you won't be assessed the AMT even if you bought some AMT-subject munis, you might be especially interested in these bonds, because their yields are typically higher than the yields on regular munis.
Other benefits of Munis - Municipal bonds are issued in two main categories: general obligation bonds and revenue bonds. General obligation bonds finance the ongoing activities of state and local governments, while revenue bonds pay for specific projects, such as airports, hospitals and other civic institutions.
So, when you invest in munis, you'll get more than tax advantages -- you'll also get the satisfaction of supporting valuable projects or services in your own state or community.
And that's not all. Consider two other benefits you may get from investing in municipal bonds:
Diversification -- By purchasing municipal bonds, you can help diversify an equity-heavy portfolio. Municipal bond prices generally do not move together with stock prices. And if you hold your municipal bonds until maturity, you can expect to receive back the principal value, along with the interest payments you received along the way.
Stability -- Municipal bonds are among the most secure investments you can own. The default rate on munis - especially general obligation bonds -- is typically quite low. Nonetheless, before you invest in a municipal bond, make sure it receives one of the highest ratings from the major bond rating agencies. You can even buy insured munis if you want an extra layer of
Which types of municipal bonds should you invest in? It can depend upon your goals, risk tolerance and time horizon. Consider purchasing a variety of short-, intermediate- and long-term munis. This type of portfolio -- known as a bond “ladder” -- can help you in all types of interest-rate environments. When market rates are down, you'll have your long-term bonds locking in higher yields. But when market rates are up, you'll have the proceeds of your short-term bonds available to reinvest.
Before purchasing municipal bonds, consult with your tax and investment professionals. You may find that munis can be a great addition to your investment