Tax Breaks Make Muni Bonds Look Good

Jan. 21, 2005 — Even if interest rates gradually increase this year, as is widely expected, municipal bonds or muni bond funds remain attractive investments.

Generally, when rates rise slowly, muni bonds retain more of their value than taxable fixed-income securities, observers note.

For people in upper income brackets who hold municipal bonds in taxable accounts, the securities currently provide returns that edge out those of U.S. Treasuries, says Standard & Poor’s chief economist David Wyss.

The bonds also make sense for people who live in states with high income tax rates, like California and New York, observers said.

Interest on municipal bonds is not subject to federal income taxes, and for the most part, if you’re a resident of the state that issued the bonds the interest is also free from state taxes. Some cities and local governments exempt interest from local taxes, too. However, bonds or shares of bond funds that are sold for a profit are still subject to taxes on capital gains.

Bonds can be bought individually, but for people who don’t have a lot of money to invest, funds can make more sense because they provide more diverse portfolios.

For people who have less than $100,000 to invest in bonds, funds are almost always the better choice, because commissions on purchases of individual bonds can be “staggering,” said Gary Schatsky, president of the Objectiveadvice Group, a fee-only financial planning firm based in New York.

Also on the downside, if a portfolio of individual bonds has to be liquidated before maturity, “transaction costs in the form of bid/ask spreads can be punishing,” said Paul Winter, the owner of Five Seasons Financial Planning, a fee-only financial planning firm in Holladay, Utah.

Wyss and Hugh McGuirk, who oversees municipal bond portfolios for T. Rowe Price Funds, said that even single-state bond funds can provide diversity, because they hold securities issued by a number of municipalities, as well as the state.