Roanoke Times
Copyright (c) 1995, Landmark Communications, Inc.
DATE: MONDAY, October 11, 1993 TAG: 9310130307
SECTION: MONEY PAGE: A-10 EDITION: METRO
SOURCE: By MAG POFF STAFF WRITER
DATELINE: LENGTH: Long
That's because passage of the Clinton budget-reduction package included substantial tax increases, particularly for the wealthy but also for many Americans on Social Security.
But are tax-free municipal bonds good investments?
That depends on whether you need tax breaks, according to the Institute of Certified Financial Planners.
And that, in turn, varies with your tax bracket, the level of risk you're willing to take and how ``munis'' fit your investment needs.
Municipal bonds - generally called munis - basically are IOUs issued by state and local governments and by special-purpose government agencies such as airport commissions or housing authorities.
The bonds come in two common varieties:
General obligation bonds that are issued by government authorities that can tax residents. They are backed by the full faith and credit of the issuing government.
Revenue bonds that are sold to raise money for specific projects such as road, utilities and college dormitories. They are paid back from revenue earned from that specific project.
In the alternative, you can invest in a mutual fund with a portfolio of municipal bonds. There are several Virginia municipal bond funds, such as those being sold by statewide banks.
In general, the institute said, the interest earned from most munis and muni funds is exempt from federal tax.
And, if you buy munis issued by governments in Virginia, the interest also is exempt from state tax. Munis bought from other states are usually not exempt from state taxes with the exception of municipal securities issued by U.S. territories.
Some muni interest is subject to the alternative minimum tax, the institute said.
And Social Security recipients must include the muni interest as part of their income when calculating whether they must pay taxes on a portion of their Social Security benefits.
Realized capital gains, or the profit you make selling a muni bond for more\ than you bought it, is subject to federal and state capital-gains taxes.
Here are some tips on municipal bonds from the certified financial planners:
Munis make sense only if their tax-free yield is higher than the after-tax yield on a taxable bond of similar quality and maturity.
If you want to know what taxable yield you'd need to match a tax-free one, divide the tax-free yield by 1 minus your own tax bracket.
For example, if you are considering a municipal bond paying 4 percent interest and you are in the 28 percent tax bracket, you subtract 28 from 1 and come up with 0.72. Divide 4 by 0.72. The product is 5.55. That means you'd need a taxable investment paying more than 5.55 percent to do better than the municipal bond yield.
However, you'd need a taxable return of only 4.7 percent if you are in a 15 percent tax bracket one reason such investments are popular among retired persons living on limited incomes.
If you have a Virginia bond, add your state tax rate to the equation.
Municipal bonds are not risk-free. Munis are graded according to their quality, so have the broker check before you buy.
Since 1980, according to the Bond Investors Association, there have been more than $1 6 billion in actual or technical defaults. Revenue bonds are especially vulnerable because revenue may not live up to projections.
Additionally, the price of munis fluctuates inversely to interest rates. So you can lose money if you sell the bond before it matures but after interest rates have risen. You would, on the other hand, gain a premium if interest rates have dropped when you sell.
Although the planners did not mention it, you can get extra protection by purchasing bonds that are insured by one of nine companies specializing in that type of insurance. In 1992, the insured market share reached 34 percent of all municipal issues, up from 16 percent in 1986.
All insured munis take on the Triple A rating of the guaranteeing insurer if it is a member of the Association of Financial Guaranty Insurors. The companies guarantee timely payment of interest and principal if the issuer defaults.
Any investment should fit the needs of your portfolio and your long-term goals.
It's important to keep your investments diversified. If your portfolio already is loaded with bonds, adding more bonds - tax-free or not - may not be the best strategy.
Investments should be driven by their investment value, not by tax considerations.
If you decide munis are right for you, you can buy them in three ways.
One method is to purchase individual bonds. These can cost as much as $25,000 for a good-quality bond, although some municipalities are selling mini-munis for as little as $100 apiece.
Another way is to buy shares in a mutual fund. Fund managers can buy
bonds from around the country or in just one state. Initial investments are much smaller, ranging from $250 to $1,000.
The third alternative is a unit trust. Like mutual funds, these trusts hold a number of issues. Unlike mutual funds, they hold a set number of municipal issues until maturity instead of trading. Trusts usually are sold in units of $5,000 to $10,000.
by CNB