For investors, the last four years have been pretty favorable from a tax standpoint. New tax laws lowered tax brackets and cut the maximum rates on long-term capital gains and stock dividends to 15 percent. Still, for 2008, investors may want to do even more to control their investment taxes. One option to consider is municipal bonds.
With municipal bonds, or "munis," investors may be able to achieve significant advantages, particularly if they’re in one of the upper tax brackets. With a muni, interest payments are free from federal taxes. If the municipality that issues the bond is located in an investor’s state, interest payments also may be exempt from state and local taxes.
In fact, the tax advantage of municipal bonds may be so great that an investor would 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, an investor’s tax bracket is 35 percent and he buys a state tax-free municipal bond that pays 5.25 percent interest. He would have to earn 8.08 percent or more on a corporate bond of similar maturity and quality to match the 5.25 percent yield of the muni. The 8.08 percent is the municipal bond’s "taxable equivalent yield." The municipal bond would provide an even greater taxable equivalent yield if the investor were in a higher tax bracket.
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). Investors who think they may have to pay the AMT should avoid these types of bonds. Conversely, if investors know they won’t be assessed the AMT, they 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.
Investing in munis yields tax advantages as well as the satisfaction of supporting valuable, local projects or services.
Additionally, by purchasing municipal bonds, investors can help diversify an equity-heavy portfolio. Municipal bond prices generally do not move together with stock prices. If investors hold municipal bonds until maturity, they can expect to receive back the principal value, along with the interest payments received along the way.
And, municipal bonds are among the most secure investments available. The default rate on munis, especially general obligation bonds, is typically quite low. Nonetheless, before investing in a municipal bond, make sure it receives one of the highest ratings from the major bond rating agencies. That means it should be AAA rated and insured so it does not fluctuate a lot during interest rate increases.
Investment Options
Consider purchasing a variety of short- and long-term munis. This type of portfolio—known as a bond ladder—works in all types of interest rate environments. When market rates are down, the long-term bonds will lock in higher yields. But when market rates are up, the proceeds of short-term bonds will be available to reinvest.
Contractors may find that the predictable source of tax-free income from tax-free bonds can be used for monthly office expenses.
Before purchasing municipal bonds, consult with a tax and investment professional. Business owners may find that munis can be a great addition to their investment holdings.