Tax Free Municipal Bonds

Muni ETF And Mutual Funds For State And Federal Tax Savings

I was recently embarrassed when a friend of mine asked if there were any tax free investments he could make that didn't involve a lot of watching over and provided an steady flow of interest or dividends, and I forgot about munis. I recommended Federal debt, such as tax free ibonds, notes or bills, because they are easily managed online through Treasury Direct are state tax free. Of course, if you're trying to limit your tax bill, beating your local sate out of their single digit percentage isn't going to make a whole lot of difference in the long run. When he did some research on his own and came up with municipal bonds as the ideal solution for his situation, I realized that I'd bought munis myself back in the earl 90's, but I'd forgotten all about them as my investment capital shifted into my tax deferred retirement accounts.

Tax free munis are far more tax efficient than tax free Federal obligations, since the Federal debt is only free from State tax, while the munis are free from Federal and State tax, at least if they are issued in the State you live in. That's why when you look at tax free muni funds, you'll see them listed by state, like "Massachusetts Tax Free" or "California Tax Free." If you don't live in that state, they will be Federal tax free, but you'll still have to pay state, and maybe even city tax. Municipal bonds aren't 100% safe, cities have been known to default from time to time, and the rating agencies have been exposed as worthless. Muni funds can spread the risk around in your state to the point where you shouldn't have to worry about default risk, but the muni mutual funds have the added risk of share value, which is basically an expression of how frightened investors are of the stock market. While the dividend payout is based on the underlying bond coupon interest rate, the value of the mutual fund shares can go up or down by double digit percentages in times of economic stress. Bond funds of all types have been enjoying an incredible, unprecedented run, due to low inflation tinged with expectations of deflation. When inflation returns, the muni mutual fund values will crash, while directly purchased municipal bonds will pay the face value at maturity/

If you don't want to buy munis directly from the issuer (normally by way of a brokerage account) and you don't like the risk of muni mutual funds, there are some new muni ETF products that are designed to maintain a somewhat constant value. They do this through an expiration date, the fund managers will dissolve the ETF as the bonds they purchase for a given target year mature, meaning the ETF investors that year should get back the face value of the bonds. iShares created a series of municipal bond ETFs this year with maturity dates between 2012 and 2017. The symbols are:

Maturity Year ETF Symbol

2012 MUAA

2013 MUAB

2014 MUAC

2015 MUAD

2016 MUAE

2017 MUAF

I haven't purchased any of these muni ETFs yet for two reasons. First, capitalization of each fund remains low, in the $10 Million to $20 Million range, which means there hasn't been much demand. Second, the trading volume is very low, from a few hundred to a few thousand shares a day. That may be positive in the sense that people are buying them for the right reason, buying to hold to maturity, but it could be costly if you need the money and have to sell out on a day with no buyers. None of the ETFs can report an average return yet (NAV) because they've only been around a few months. Just keep in mind that the average muni bond coupon rate in the ETF won't translate into your return because the bonds are purchased in the secondary market, where the return is discounted into the future by the sellers.

Like all tax free investments, they are worth to people in high income brackets than to the working middle class. So, lets take the extremes of a married joint filer in the 10% bracket and a married joint filer in the 35% bracket, both living in Massachusetts with a $100,000 portfolio of Massachusetts muni bonds, state and federal tax free. And lets say those munis pay out at 5% in the current year. On the $5000 of interest income, neither will pay any taxes to either the Massachusetts Department of Revenue or the Internal Revenue Service, but the savings are very unequal. The high income married couple is saving 35% Federal Tax plus 5.3% State Tax for a total of 40.3% of $5,000 or $2015. The return for the high income muni holder is equivalent to a taxable investment paying 8.375%.

Now lets consider the low income marries joint filer paying 10% Federal Tax plus 5.3% State Tax for a total of 15.3% of $5,000 or $765 dollars. The lower income individual making the exact same investment gets tax savings of just over a third of what the high income individual sees. The return for the low muni investor is equivalent to a taxable investment paying 5.90%. The low income investor can probably do better by buying AAA taxable bonds and paying the taxes, while the high income investor probably can't beat his 8.375% equivalent return without taking on more risk than a muni portfolio presents. So, the rich get richer!

I've written a bit about calculating interest rates and using the mortgage formula and I think I'm planning something on stock dividends and their tax implications, along with some other basic calculations that people should really take into account in their investing.