December 31st, 2012... It's a date that every income investor in
America is surely aware of.
On that day, the "Bush" era tax cuts are set to expire. If Congress
doesn't intervene, dividends will be taxed as ordinary income, and
yourmarginal tax rate could go up.
The 33% marginal tax rate will increase to 36% and the 35% bracket
to 39.6%. In addition,taxpayers in the top two tax brackets will be
hit with a 3.8%Medicare surtax on investment income. That means you
could be forking over as much as 43.4% of yourdividend income to
While there's no telling how this situation will pan-out in
Congress, if the prospect of higher-taxes keeps you up at night,
then you do have some options.
Oneasset class still offers steady dividends, above-average yields,
and better yet... the distributions you receive from these
investments are 100%tax free .
I'm talking about municipal bonds.
Municipal bonds, or munis, arebonds issued by states, cities, and
agencies to raise money to build bridges, highways and other
infrastructure. These bonds come in two main types --
generalobligation bonds and revenue bonds.
Most general obligation bonds are backed by the full faith and
credit as well as taxing power of the government that issued them.
In contrast, most revenue bonds are issued for improvements that
generate income from power plants, airports, swimming pools, and
other projects. Because there is often more risk associated with
these bonds, they tend to pay higher yields.
While some munis are taxable, most throw off interest income that's
exempt from federal incometaxes . As a result, to compare theyield
on a tax-exempt muni to the yield on a taxable security, you need
to look at the muni's taxable-equivalent yield.
That's the yield needed on a taxable investment you'd need to find
to make it equal to that of a tax-free munibond . The formula for
calculating a muni's taxable-equivalent yield is:
Muni yield / (1 - Your FederalTax Bracket
For example, one of my topmunicipal bond fund picks,
American Municipal Income Portfolio (NYSE:
sports a nominal yield of 5.6%. But if you're in the top (35%) tax
bracket, XAA's taxable-equivalent yield is a whopping 8.6%
You can see why muni bonds are so attractive to the top wage
earners in the country, married couples filing jointly that make
$388,350-plus a year.
But the taxable-equivalent yields are still very robust even if
you're income is far less. If you're a married couple in the 28%
bracket ($142,700 to $217,450), thetaxable equivalent yield on XAA
is still 7.8%. For joint filers in the 25% bracket ($70,700 to
$142,700), the taxable-equivalent yield of 7.5% is certainly
nothing to sneeze at.
If the tax advantage of municipal bonds has you thinking about
investing, you're probably concerned aboutdefault risk .
Recentmunicipal bond defaults by three California cities --
Stockton, San Bernadino, and Mammoth Lakes -- have rattled some
muni investors. The defaults were even enough to turn Warren
Buffett, who had been sanguine on munis, cautious. The billionaire
investor commented in July on Bloomberg TV that declaring default
has become less of a "stigma" given that some cities haven't
honored their obligations. Moreover, the fact they defaulted makes
it more likely other cities will follow suit.
Still, municipal defaults are, in fact, reasonably rare. Between
1970 and 2009 there were only 54 municipal defaults and only three
on general obligation debt, according to Moody's. The last state to
default was Arkansas in 1933, during the depths of the
So far in 2012 there have been nine municipal bankruptcy filings
worth a total of about $1 billion in value. That amount is less
than 0.03% of the total value of munis outstanding.
If the recent defaults still make you wary, then you can always
mitigate risk by investing in a municipal bond fund. By holding a
portfolio of municipal bonds, a fund can minimize the impact of any
single bond that may go into default.
That's one reason I like American Municipal Income Portfolio right
now. With nearly 130 holdings, XAA is well diversified. The highest
concentration is in healthcare revenue bonds (37%), followed by
general obligation (22%) and education revenue bonds (10%).
However, just because abond fund is diversified, it doesn'tmean it
is without risk. With an average maturity of just over 18 years, a
lot of XAA's holdings are positioned at the long end of the credit
spectrum. If interest rates begin to rise, the fund could get
Action to Take -->
That said, municipal bonds are one of the few asset classes
thatoffer tax-exempt income. And unless Congress acts quickly, muni
bonds' tax-free yields will be an even bigger benefit come December
-- Carla Pasternak
Carla Pasternak does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.
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