By Daniel Lippincott
The Daily Record Newswire
With the possible expiration of the tax cuts provided by the Jobs and Growth Tax Relief Reconciliation Act of 2003, and the tax increases scheduled under the health care bill, investors should be prepared to foot a greater share of the tax bill.
If Congress allows the tax cuts to expire at year end, the top tax rate on ordinary income will rise from 35 percent to 39.6 percent, while tax on dividends for the highest earners will jump from 15 percent to 39.6 percent — although Treasury Secretary Timothy Geithner recently noted that the Obama administration hopes to hold the rate to 20 percent on dividends.
If all of that weren’t enough, a new Medicare tax of 3.8 percent on investment income — including capital gains, interest and dividends — is scheduled to go into effect in 2013.
Where, then, can investors looking to minimize their tax burden turn? One option worth looking into is investments that provide tax-free income, such as municipal bonds, which allow an investor to earn a steady stream of income that will become more valuable as taxes increase.
To illustrate why investments that provide tax-free income will be advantageous, look at the yield on a 10-year, AAA-rated municipal bond versus a comparable Treasury bond:
Tax Rate (2010) 35% (2011) 39.6% (2013) 39.6%+3.8%
10-year muni (taxable equivalent) (2010) 4.46% (2011) 4.8% (2013) 5.12%
10-year Treasury (2010) 3.1% (2011) 3.1% (2013) 3.1%
As taxes increase from 35 percent to 39.6 percent in 2011, the 10-year municipal bond yield advantage rises from 1.36 percent to 1.70 percent. Municipal yield becomes even more attractive in 2013, when the 3.8 percent Medicare tax goes into effect, pushing the yield advantage to 2.02 percent.
Before rushing out to buy a municipal bond with an attractive yield, an investor should prudently review the available issues and fully understand how issuers will repay their bonds.
There are two basic categories — general obligation bonds and revenue bonds. General obligation bonds are secured by the full faith, credit and general taxing powers of the issuer. They represent a promise by the issuing municipality to levy enough taxes as necessary in order to make timely and complete payments to investors.
In contrast, revenue bonds are secured by revenues from the projects being financed. Since revenue bonds are not backed by the issuers’ taxing authority, generally they are considered more risky than GOs, and therefore tend to offer higher interest rates.
One notable exception is essential service revenue bonds, considered fundamental to the operation of government — water and sewer utilities, and state highway authorities. In Moody’s 2002 study of municipal bond defaults, no Moody’s-rated GO or essential service revenue defaulted from 1970 through 2000.
In addition to GOs and revenue bonds, pre-refunded bonds and escrowed-to-maturity bonds represent another safe option. Pre-refunded and ETM bonds have the funds required to pay off the bonds set aside in an escrow account, typically in the form of a Treasury. The structure typically is used to reduce interest expenses for the issuer.
As with all investments, in making decisions it is critical to remember to diversify the municipal bond portfolio to protect against both interest rate and geographic risks. Investors should stay within their risk tolerance so they do not risk principle in search of greater tax-free income. Undoubtedly, several alternatives to buying individual bonds can be found, including mutual funds, closed-end funds and exchange traded funds. No matter which type of investment is chosen, ask questions and seek advice from a professional money manager whenever something doesn’t make sense.
Daniel Lippincott is a senior tax sensitive manager/municipal analyst for Karpus Investment Management. He can be reached at (585) 586-4680.
