A Less Taxing Way To Invest

The yields on municipal bond funds are tempting -- and tax exempt, too

won’t shoot out the lights for you, but they’ll provide steady income and help to stabilize your portfolio,” says Overstreet.

Recently, these two Vanguard funds were yielding 4.1% and 3.0%, respectively, tax-exempt, which compares favorably with intermediate- and short-term taxable yields. Vanguard’s limited-term fund has a lower yield because it holds bonds with a shorter maturity, which means it will hold more value if rates move up. In 1999, the last year interest rates rose sharply, Vanguard’s intermediate-term fund lost only 0.50%, while the limited-term fund managed to gain 1.47%.

Municipal bond funds can be sliced into short-, medium-, and long-term vehicles, and they can also be diced into national and single-state funds. A resident of Ohio, for example, will owe taxes to Ohio on income from a national muni fund. That investor, however, can avoid state and federal income taxes by investing in a fund that only owns municipal bonds issued in Ohio. “If you are in a high-tax state, such as California or New York, you’ll be better off, after-taxes, with a single-state muni fund,” says Berry.

Investors in municipal bond funds have yet another option: Invest in a high-yield muni fund. As the name suggests, you can get higher tax-exempt yields (recently, the average was 5.2%) if you’re willing to put money into riskier bonds. “High-yield municipal bond funds might make sense for a small part of your portfolio,” says Overstreet. Tankersley concurs, noting that an improving economy will likely hold down state or municipal defaults, which are the main risk in the high-yield bond market. According to Morningstar, American Funds High-Income Municipal Bond A (AMHIX), which leads the category in five-year return and yields 4.7%, is a “prudent way to navigate a volatile investment arena.”

Now a word of caution: Whichever type of municipal bond fund you choose, you should consider its ownership of bonds that are exposed to the alternative minimum tax (AMT). The AMT requires taxpayers to add back certain allowable deductions and adjustments when calculating their income tax, including state and local income taxes; property taxes; and some investment and medical expenses. If the deductions add up to a disproportionate share of your income, you could be hit with the AMT. “The AMT is becoming a bigger issue, and more investors are [getting] caught in the AMT trap,” says Berry. “Some municipal bond funds buy AMT bonds to increase their yields. For investors who pay the AMT, a portion of the yield can be taxable, which can defeat the purpose of buying a municipal bond fund.” If a fund has 40% of its assets in AMT bonds, for example, 40% of its distributions might be taxable. “Fortunately, there are muni funds that hold few or no AMT bonds. Check with the fund before buying if the AMT is a concern,” says Berry.

Now a word of caution: Whichever type of municipal bond fund you choose, you should consider its ownership of bonds that are exposed to the alternative minimum tax (AMT)

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