For years a tried and true investment was a tax free municipal bond. If you were in a high tax bracket you could write off your federal taxes and sometimes even your state and local taxes on the interest gained. With a carefully chosen bond you could get a better return than with a US Treasury. And in an era when the top tax rate was 89% it made perfect sense to go the tax free municipal bond route. Now there is talk of fixing America’s ailing infrastructure using seed money from the federal government and bonds issued by state and municipal governments. Are tax free municipal bonds a good idea today? Especially are they a good idea when interest rates may be going up while states are strapped with debt?
How to Invest in “Munis”
Years ago we wrote about how to invest in municipal bonds AKA “Munis”.
Municipal bonds are an attractive investment for many and can be invested in by buying individual bonds, shares of bond funds, or shares of unit investment trusts. How to invest in municipal bonds may vary with how much money the investor has to invest and his or her level of income. Tax free municipal bonds are typically more attractive to high income investors.
The two types of municipal bonds are general obligation bonds and revenue bonds. General obligation bonds are sold to cover expenses of states and municipalities. The taxing power of the issuing authority is your protection against default. Revenue bonds are what are issued for infrastructure projects. And revenue from the project such as tolls for roads or bridges provides the income stream to pay interest and eventually principle on the bonds.
Be careful when investing in municipal bonds, tax free or not. Some municipalities and states are so strapped for cash that not only repayment of the principal but also payment of interest may be at risk. Standard & Poor’s and Moody’s provide credit ratings where Aaa and AAA are ideal ratings and D, DD or DDD are for bonds that are in default. Tax free municipals are not a good idea if the issuer is in default.
Where Are Interest Rates Going?
Municipal bonds are long term instruments. If you put all of you investment into a bond today and interest rates go up you will be stuck with an interest rate that is less than the current market and that will last for years. An approach that long term bond investors take is to create a bond ladder. They invest a set amount each year in bonds, hold to maturity, and reinvest when the bonds mature. This passive approach to bond investing provides a long term income stream and an average interest rate over time.
What Is Your Tax Bracket?
If you are in today’s top tax bracket you will pay 39.6% federal tax on the last dollar of adjusted gross income for a single person. In 1963 you would have paid 53%. But back in the 1960’s a person with an adjusted gross income of $10,000,000 would have paid 89% on the last dollar earned. Today the rate does not keep going up after a single person makes half a million. The point of these numbers is that tax free municipals were a great idea for folks in the really high income brackets for much of the 20th century up until the Reagan tax cuts in the 1980s. Today you need to take out paper and pencil and calculate how much of a benefit you will gain from having the last dollar you earn be tax free from federal taxes and perhaps from state taxes.