By Carolyn Bigda and Kathy Kristof | From Kiplinger's Personal Finance, June 2015
Tax perks can enhance the value of muni returns even more, especially for residents of high-tax states.
Don’t be put off by these seemingly low yields. Interest from muni bonds is exempt from federal taxes. And if you buy munis issued by your home state, they’re also likely to be free of state taxes (and possibly local income taxes, too). With the top federal tax bracket at 39.6% and investment income for high earners subject to a 3.8% excise tax under the Affordable Care Act, even a modest yield on a tax-free investment looks pretty good, says Marilyn Cohen, CEO of Envision Capital Management, in El Segundo, Calif.
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Consider a high-quality muni bond maturing in 10 years and yielding 3%. For top earners, that’s the equivalent of 5.3% from a taxable bond, and it’s way above the 1.9% yield of a 10-year Treasury bond. But avoid munis if you’re in a lower tax bracket or investing through tax-favored retirement plans. Retirees should also know that although the interest earned on munis is not taxed by Uncle Sam, it’s added in when you calculate your modified adjusted gross income, which the IRS uses to determine how much of your Social Security income is taxable. Thus, muni interest could subject more of your Social Security benefits to taxes.
What could go wrong: Defaults are rare, but the finances of some states and municipalities are wobbly. Some cities could even file for bankruptcy. Rising
interest rates would also cause the value of existing bonds to fall. That’s not a problem if you own individual bonds and hold to maturity. For those investors, the biggest risk is inflation, which eats into the value of your principal and the fixed stream of interest payments.
How to play them: Avoid sketchy issuers, and keep bond maturities relatively short to dampen the impact of rising rates. For those living in high-tax states, such as California, New York and New Jersey, it makes sense to stick with bonds issued by your state of residence or state-specific bond funds. California residents should consider T. Rowe Price California Tax-Free Bond (symbol PRXCX ), which yields 2.0%. That’s the equivalent of a taxable 4.0% for the highest-income Californian. The fund’s average maturity—17 years—is on the high side. But its average duration, a measure of interest-rate sensitivity, is a tolerable 5.0 years (the figure suggests that if rates were to rise by one percentage point, the fund’s share price would drop by 5.0%).
If state taxes aren’t a big issue, you may do better by buying a multistate muni fund. For example, Vanguard Long-Term Tax-Exempt Investor (VWLTX ), with an average duration of 6.0 years, yields 2.2%. That’s the equivalent of 3.9% for someone in the highest tax bracket and a respectable 3.1% even for someone with a marginal tax rate of 28%.
Prefer individual bonds? Recently, a California Department of Veterans Affairs bond, rated double-A, yielded 2.9% to maturity in 2025. And a New York City Housing Development Corp. bond, rated double-A-plus, yielded 2.6% to maturity in 2024.