There are people so averse to paying any taxes that they actually harm their individual investment returns. This harm has come over past years in many forms and fashions but of particular interest to me are municipal bonds.
“Muni bonds,” as they are called, are issued by municipal authorities rather than the federal government. They provide tax-free income to the investor (assuming you have no alternative tax issues) and tax-free is always good – right? Not so fast.
Municipal bonds are issued for school projects, roads, water plants and the like, and the motive of the issuer is not to give you tax-free income, but rather to finance a public project with private money. This is not philanthropy in action! The issuing authority is trying to raise dollars and they frankly don’t care if that comes from one source or 1,000. They just need the money to do the job.
What yield does a municipal bond pay? That depends on the current economics, the apparent risk of the project and the type of municipal bond being issued. In other words, this changes all the time. The bond could be referred to as a “general obligation,” meaning that as long as the city or state can charge property taxes you should get your money back. Keep in mind municipalities can and have gone bankrupt in the past. A “revenue obligation” is a bond where the income payments and repayment of your principal come from the underlying project.
Typically a revenue bond will pay a higher yield than a general obligation because it is presumed there is more risk involved. The question for all investors is what is the current yield of a regular bond with similar credit risk and time to maturity?
That may seem a little complicated so let’s use numbers. Pretend we can buy a good quality municipal bond with an effective yield of 4%. This is a made up number but in the ball park. The income would be tax-free on the federal level because it is a municipal bond.
If we purchased a similar credit quality corporate bond the yield may be 5.5 percent but it would be fully taxable. This is why the determination of what bond to buy is both an investing and a tax issue. Most of us dislike taxes, but in many instances I find that people should have opted to buy the taxable bond, pay the taxes, and walk away with more money net return after tax.
If you are in the 20 percent tax bracket you would lose 1.1 percent of the yield to Uncle Sam, but that still leaves 4.4 percent after taxes which is greater than the 4 percent municipal bond. The lower your tax bracket, the less likely you should use municipal bonds.
Please work with both your investment advisor and your tax professional to determine what is best for you. The numbers change all the time and need to be examined before investing.
Joseph “Big Joe” Clark is a certified financial planner and the managing partner of the Financial Enhancement Group, LLC. Big Joe can be reached at bigjoe@yourlifeafterwork.com, or (765)-640-1524.
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Big Joe Clark: Tax-free not always good
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