By BRIAN HEPP
Every year we, as Americans, face the annual ritual of filing tax returns. While the process is unavoidable, investors frequently look for effective ways to lessen the impact of taxes on the overall returns of their portfolios. More investors — particularly those in higher tax brackets — are finding that municipal bonds can help reduce their tax burden, and at the same time add stability and diversification to their portfolios.
Issued by state and local governments, municipal bonds are commonly used to raise money for community projects and improvements. These include a broad range of developments, such as new highways, improved sewer systems, or even new school buildings. As with other bonds, by purchasing a municipal bond, you’re really making a loan to the issuing municipality. That state or local government, in turn, promises to pay you a given rate of interest while you hold the bond and return your principal at maturity.
One of the most attractive features of municipal bonds is their freedom from certain taxes. The bonds typically pay interest every six months and, unlike other investments, the interest you earn is not subject to federal taxes. In addition, this tax exemption can extend to state and local taxes if you reside in the state or community where the bonds were issued. Keep in mind, certain types of municipal bonds may be subject to state or local taxes, or the alternative minimum tax, so it’s important to know exactly how specific issues will be treated before making a purchase.
Whether or not a municipal bond is subject to state or local taxes, its freedom from federal taxes on the interest it earns can significantly increase the after-tax return of your portfolio. Investing in municipal bonds can allow you to possibly diminish your overall tax burden by decreasing the amount of your income subject to taxes. Less money spent on taxes means more money to spend on other pursuits. Or, if you so choose, there will be more money available for reinvesting or saving.
While the tax advantages of municipal bonds may be appealing, several other qualities can make them an important addition to an investor’s portfolio. For one thing, you can enjoy interest payments every six months. In addition, though it does not eliminate the credit risk of bonds, many are backed by insurance, thereby increasing the security of your investment. The credit enhancement does not remove market risk of the bonds, and there is no assurance as to the insurer’s ability to meet its commitments. Keep in mind bonds may be worth more or less than their original cost upon redemption or upon sale prior to redemption.
Bonds can be bought and sold in the open market, so you do have the opportunity to liquidate your bond before it matures. Investors should keep in mind that as interest rates rise, existing bond prices of already outstanding fixed income securities tend to fall. Long-term bonds are generally more exposed to interest rate risk than short-term bonds. Depending on current interest rates, the price you receive may be more or less than your original investment, but you do have the option to sell should you need to.
Finally, almost every state and thousands of municipalities issue bonds each year, so you have a wide variety to choose from. With maturities ranging anywhere from one to 30 years, you can plan for current or future income. And the variety of available bonds lets you easily diversify your municipal bond holdings. (Brian Hepp is a financial consultant for Santa Monica-based A.G. Edwards & Sons, Inc. Member SIPC. He (310) 453-0077 or at A.G. Edwards is a full-service retail brokerage firm that offers a complete spectrum of financial products and services, including stocks, bonds and mutual funds, financial retirement planning and tax-advantage investments.)
Originally published in the Santa Monica Daily Press print edition on March 9, 2006. Read the original PDF.