One Way to Beat the Tax Man

One Way to Beat the Tax Man

Shining a Light on Munis

If you live in the right state, munis can triple your tax exemption.

Municipal bonds have long worn a veil of obscurity. But they are becoming friendlier to small investors, thanks in part to rule changes by the Securities and Exchange Commission.

These rules require muni bond underwriters to keep small investors well informed about financial factors that might affect the issuers’ credit rating by providing them with annual financial reports and disclosing all important information regarding muni bonds.

At the same time, the Public Securities Association, a trade group in New York, with the Standard & Poor’s Corp made it easier for small investors to get the best muni’s bond prices available with two services on the market.

The first is the PSA/Bloomberg National Municipal Bond Yields, a yield scale that publishes in many media across the country. The second is the Standard & Poor’s/PSA Municipal Bond Service, a toll-free hotline that provides the transaction prices (or an evaluation of the prices from Standard & Poor’s Corp) and the yields of muni bonds.

For investors grappling with high tax rates, municipal bonds may be a way to make tax time less painful. Munitipal bonds, or munis, are debt obligations issued by city, state, and local governments. The appeal of munis is that interest income is exempt from federal taxes, making them one of the few tax shelters around. Better yet, taxpayers in some localities can get even more tax breaks from buying munis issued by their home states.

Tax rules vary from state to state, so it’s wise to find out about local laws. Residents of high-tax states, may do well to allocate a good portion of their municipal investments to munis sold by their home state. The benefits of doing so include a double and sometimes triple tax exemption. For resisdents of some other states, it’s a wash, since most of in-state bonds are taxed the same as out-of-state bonds. In a few states, municipal-bond interest is tax-free, regardless of where the bonds were issued.

Who can beat a tax man? Photo by Elena

And residents of low or no-tax states would be better off putting their money into a more diversified portfolio of quality bonds.

Municipal bonds are sold by brokers and require a $5,000 minimum investment. One way to get around this is to invest in a municipal bond mutual fund. There are nearly 1,000 muni funds, including 700 or so single-state funds, according to research firms that track mutual funds. Muni bond funds carry another important plus: They are less risky because they offer geographic diversity.

A few caveats: Munis often have higher transaction costs than Treasuries, driving down their effective yields. When shopping for muni bonds, check the credit quality, that is, the strength of the cash flow used to meet principal and interest payments. Your fund’s bonds should have an average credit quality of A or better from one of the major rating agencies. High-quality bonds hold up better during bad times.

Two ways to find more about mysterious municipal funds

Municipal funds have long worn a veil of obscurity. But they are becoming friendlier to small investors, thanks in part to rule changes by the Securities and Exchange Commission.

These rules require muni bond underwriters to keep small investors well informed about financial factors that might affect the issuers’ credit rating by providing them with annual financial reports and disclosing all important information regarding muni bonds.

At the same time, the Public Securities Association, a trade group in New York, is working with the Standard & Poor ‘s Corp. to make it easier for small investors to get the best muni’s bond prices available with these services: the PSA/Bloomberg National Municipal Bond Yields, a yield scale that is published regularly. The second is the Standard & Poor’s/PSA Municipal Bond Service, a tall-free hotline that provides the transaction prices (or an evaluation of the prices from Standard & Poor’s Corp.) and the yields of muni bonds.