The secret is out: The safe, reliable, tax-free returns of munis are stirring interest in shaken investors.
WHILE A RELIABLE, albeit modest, return is attractive by itself, the real beauty of munis lies in their tax benefits. The interest on these bonds is free of any federal -- and often state and local -- tax. This perk encourages investors to buy low-return munis, which finance everything from highway repair to stadium construction. And this tax break goes a long way. Say you fall in the 30% tax bracket. In order to get the same return that a muni with a 5.5% tax-free yield offers, you'd need a 7.86% return on a taxable investment. In the 35% tax bracket, you'd need an 8.46% taxable return to achieve the same result. As you can see, Uncle Sam's largesse adds up.
Because of their tax-exempt feature, these bonds best serve investors in the 30% tax bracket and higher. (Remember to include state and local income taxes in your calculations.) Folks in lower tax brackets may be better off parking their money in stocks or mutual funds that offer higher potential returns after taxes. Currently, the benchmark 10-year Treasury note, which is subject to federal taxes, carries a 4.79% yield, while a 10-year muni has an average 4.30% yield. Yields on tax-free munis range from 2.16% for a two-year bond to 5.19% for a 30-year bond, according to Bloomberg.
As you research, focus on munis in your own state, since most states don't tax residents on the interest accrued on these types of bonds. (That's why munis can be especially attractive to folks in high-tax states like California and New York.) And depending on the specific muni, local taxes may also be withheld. Keep in mind these in-state tax rules often don't apply if you purchase another state's munis. Of course, a stellar return on an out-of-state muni may compensate for the potential tax hit, so crunch the numbers first before you leap. Remember, there are some 50,000 muni issuers nationwide, so chances are you'll be able to find a suitable offering close to home. (By the way, don't even think about putting munis in an IRA. These vehicles already allow investments to grow tax-free, and superior returns can be found elsewhere.) Keep in mind that the income from some munis -- typically those involving a public and private partnership, say for a stadium project -- is subject to the alternative minimum tax, or AMT.
Next: Part 3: Risks and Rewards