May 1999

What's New in Finances

Savings bonds stop earning interest

5/1/1999 -

Consider municipal bonds for your investment portfolio

Municipal bonds pay interest that is exempt from federal income tax, so they might seem like great investments for everyone. Unfortunately, they aren’t. Whether you buy municipal bonds directly or through a mutual fund, here are some issues to consider.

* Do municipal bonds fit your portfolio? For most people, it makes good financial sense to own a mix of stocks and bonds. Stocks have historically provided growth in excess of the inflation rate, while bonds pay steady income. If your portfolio is already tilted heavily towards bonds, you may not need any more – even tax-exempt bonds.

* Do municipal bonds make sense in your tax bracket? Surprising as it may seem, some people are better off owning taxable bonds. For example, say you’re in the 28% tax bracket. Let’s also assume that taxable bonds are yielding 6%, while comparable municipal bonds are yielding 4%. If you invest in taxable bonds, you’ll be left with 4.32% yield after taxes, which is more than you would earn from the municipals. In this case, as in many real-life cases, the combination of your tax bracket and the municipal bond yield makes taxable bonds more attractive.

* Are there other tax considerations? Retirees should be aware that municipal bond interest can actually increase the tax on their social security benefits. And any individual who is concerned about the alternative minimum tax (AMT) should be aware that income from certain "private activity" municipal bonds isn’t tax-exempt for purposes of the AMT.

* Are you buying quality? Like corporate bonds, municipal bonds vary widely in quality. Before you buy any municipal bond or mutual fund, find out how it’s rated by Moody’s, Standard & Poor’s, or some other reputable rating service.