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The interest paid on (tax-free municipal) bonds is exempt from federal taxation.
Billy Peterson, CFP ® Peterson Wealth Services, Inc. 877-470-4002 www.petersonwealthservices.com
A Little Home Cooking
by Billy Peterson
This time of year I will undoubtedly hear com- ments from disgruntled individuals about their tax bill and how they dread writing the check
to the Internal Revenue Service. It’s understandable that we don’t usually feel good about coughing up big chunks of our hard-earned income to the Federal, State, or Local Government. So that’s why I’m going to share with you a certain investment vehicle that can help you reduce that bite.
We’re all familiar with Certificates of Deposit (CDs). You agree to “deposit” your money for a stated term and in return the bank agrees to pay you a stated interest rate. The interest you earn on the CD is fully taxable so a stated 2 percent CD will net you approxi- mately 1.3 percent after tax (at a 35 percent federal tax rate). If you are subject to state tax the net return will be even less.*
Here’s an alternative to taxable investments such as CDs: Tax-Free Municipal Bonds. The interest
paid on these bonds is exempt from federal taxation. Additionally, if you reside in the state in which the bond was issued you can avoid paying state tax on the interest. This is particularly beneficial to those who reside in states with high income tax rates such as California, Oregon, Idaho and many eastern states. For example, a California resident in the highest Federal and State tax bracket would pay nearly half of his/her taxable interest income in taxes. A 5 percent taxable bond would net approximately 2.7 percent after State and Federal taxes.**
Municipal bonds have greater volatility than CDs. A municipal bond is essentially a promissory note. When an investor buys a municipal bond he/she is lending money to the issuing state or local govern- ment. In return for the loan the issuer pays interest
at a specified rate and, at the end of the period, pays back the principal. Sound familiar? Funds raised through the sale of municipal bonds are generally used to finance projects that benefit the public. Many people like the idea of supporting local projects and that is where the “home cooking” comes from. The two most common types of municipal bonds are general obligation bonds and revenue bonds. General obligation bonds are backed by the “full faith and credit” and the taxing power of the issuer. They are normally viewed as the type of municipal bond with less risk. Think school districts, water and sewer sys- tems, etc. Revenue bonds are secured by the income from the specific project they were issued to finance.
Think toll roads, hospitals or airports, for example. The popularity of municipal bonds has soared
among individuals in recent years as they seek to combat the inherent penalties of high income. These penalties include deduction and exemption limita- tions and higher marginal tax rates. Notably, many economists and political pundits believe the current administration will be raising taxes in the not-distant future. That possibility makes municipal bonds even more attractive. It is important to pay attention to the rating assigned to each bond. Rating agencies will assign a letter “grade” to each bond illustrating the financial stability and assumption of timely interest payments. Bonds rated AA** or higher are typically the highest quality and bonds rated BB** or lower are considered higher risk. Issuers with higher risk pro- files will need to pay a higher interest rate to attract investors.***Ratings are subject to change.
Don’t be alarmed when you initially see the stated municipal bond interest rate (also known as the coupon). Munis will generally carry a lower coupon than a taxable bond with a similar maturity. But be sure to calcu-
late the tax equivalent yield. For example, a 4 percent municipal bond would be equivalent to a 6.15 percent taxable bond (35 percent federal tax rate), and would be equivalent to a 7.69 percent bond with a 35 percent fed- eral plus 10.55 percent state tax rate. It is worthwhile to compare tax-free rates to the taxable rates on a net basis.
Municipal bonds are available for purchase at most brokerage firms and at some banks. Talk to your financial advisor and/or CPA to determine if munici- pal bonds would be appropriate for you.
*The illustrations given in this commentary are hypo-
thetical examples and do not intend to reflect the performance of any particular security. Tax laws are subject to change. Consult your tax professional for further details.
**Quoted from Moodys rating agency
*** High yield bonds are not suitable for all investors.
When appropriate, these bonds should only comprise a modest portion of your portfolio.
DISCLAIMER: The above information and content are general in nature for informational purposes only and do not constitute financial advice or investment recom- mendations. Speedhorse Magazine makes no endorsements and bears no liability for your use of the information provided in this column. Always consult a suitably quali- fied financial professional and/or tax professional on any specific problem, issue or investment opportunity.
MUNICIPAL BONDS
18 SPEEDHORSE, March 2, 2012
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