By Kevin FitzGerald
For most of the year the Federal Reserve has been increasing the interest rates. It looks like they may be coming to a peak. My wife and I both work and our tax rate seems high. I’ve never looked at municipal bonds, but recently someone has recommended them to me. Can you give me a few details?
— K.O., Hoboken, N.J.
As Ben Franklin once said, "Nothing in this world is certain but death and taxes." And, while taxes may be certain, they certainly aren’t predictable these days. Although many tax changes in the last decade were designed to simplify and reduce taxes for many individuals, the truth of the matter is that many people are still seeking ways to manage their taxable income.
However, don’t despair. There are still some viable tax-advantaged investments that affluent investors should consider.
The first tax shelters
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One of the very first tax shelters is still one of the most popular. When congress adopted the 16th Amendment in 1913 authorizing a federal income tax, resourceful investors discovered that first tax shelter — municipal bonds.
Municipal bonds are debt obligations issued by states, cities, towns, or public commissions to provide money for schools, hospitals and other public works. These securities provide income that is free of federal and, in some cases, state and local income taxes.
For the investor, this tax-free benefit can be quite considerable. For instance, a married couple in the 31 percent federal tax bracket would need to earn nearly 8 percent on a taxable investment to equal a 5.50 percent tax-exempt yield. If state and local taxes are also accounted for, an even higher return on a taxable investment vehicle would be needed. (Although income generated by most municipal bonds is exempt from taxes, remember that any capital gains earned from the sale of these bonds is subject to taxation.)
Investors may choose from a wide array of municipal bonds with varying maturities. Shares in a municipal bond portfolio may also be purchased through municipal bond trusts or mutual funds, which have the added benefit of professional selection and, in the case of mutual funds, on-going professional management.
Investors choosing municipal bond mutual funds may achieve safety through a greater degree of diversification than they would be able to achieve on their own. In addition, unlike the actual bond which pays semi-annual or annual interest, municipal bond funds pay monthly tax-free income. That income may be reinvested (usually at no charge), thus compounding the tax savings.
There are a host of tax-free municipal bond mutual funds to suit a variety of investor needs. For example, high yield, tax-free municipal bond funds invest in primarily medium- and lower-grade municipal securities. Although these funds entail a greater degree of risk, they also typically earn a higher yield, which, when combined with the tax advantages, can provide very attractive returns. On the other hand, the majority of municipal bond funds invest in higher quality securities that are rated within the top four categories by Standard & Poor’s and Moody’s.
For investors residing in states such as California and New York where state income tax is very high, there are single state municipal bond funds available that provide a "double tax-free" benefit — they are exempt from both the federal and state income taxes.
With the continuing need to actually keep more of what is earned, investors should take a close look at their portfolios to determine what tax-saving strategies might be appropriate. In addition to tax-exempt investments, such as municipal bonds, investors may also consider tax-deferred investments, such as IRAs, and 401(K) plans, and direct investments to help reduce their tax burden.
It’s important to be aware of tax saving strategies all year — not just as we approach April 15. Ben Franklin also said that a penny saved is a penny earned. For investors who seek to manage their tax liability, they may be able to save more of those pennies come next April 15.
The information contained herein has been obtained from sources believed to be reliable, but we cannot guarantee its accuracy or completeness. Neither the information or any opinion expressed constitutes a solicitation for the purchase or sale of any security.
Kevin Fitzgerald is first vice president-Investments at PaineWebber. He focuses on the areas of professional money management, asset allocation and retirement planning. He can be reached at 1 (800) 423-3381.