Many successful investors will be in for a shock during upcoming tax seasons. There is nothing worse than having a banner year in the financial markets, then having to give a large portion of it to Uncle Sam in the form of taxes.
Frankly, I'm concerned that the pain is going to be worse for winning investors who have failed to prepare themselves for the new era of higher tax rates.
Here's what the new tax laws mean to you
If you are in the top tax bracket, meaning you earn more than $400,000 (or $450,000 for married couples), then your marginal tax rate will jump to 39.6% and the rate on long-term capital gains and dividend interest will increase five percentage points to 20% for the 2013 tax year. A new 3.8% tax related to the Affordable Care Act (more commonly known as "Obamacare") and a 0.9% Medicare surtax are also going to hit taxpayers who make more than $200,000 (or $250,000 for married couples) in modified, adjusted gross income.
That's why it's important to design your investment portfolio in the most tax-efficient way, even if you are under this threshold. Investing within a retirement account and diversifying into tax-advantaged instruments is the primary way to lessen your tax burden.
And one of the most widely used tax-exempt instruments in the market are municipal bond funds.
Let me explain...
Municipal bonds, also known as munis, are debt instruments issued by public entities like cities, states and counties, which use the proceeds to fund various public works projects such as roads, schools and power plants. These bonds can be based on revenue or general obligations. Revenue-based bonds are issued by non-profit and public-service organizations like utility companies or hospitals, rather than the government. They are dependent upon the revenue of the specific projects they are created to fund. In contrast, general-obligation bonds are backed by the government issuer, which can allocate or increase taxes to assure the interest is paid and principal is returned.
Why do munis make sense now?
The short answer is because the interest earned from owning municipal bonds and municipal bond funds is generally exempt from federal income taxes. In addition, depending on the issuer, they can be exempt from state or local taxes.
1. Invesco Value Municipal Income Trust (NYSE: IIM)
This fund is built with tax-free, fixed-income instruments consisting primarily of municipal bonds rated "A" or better. It yields about 5.6%. If you are in the 35% tax bracket, then this tax-free yield is equivalent to an almost 8.6% taxable yield.
This example clearly shows the benefits of investing in tax-free municipal bond funds. As taxes increase, so will the benefits. IIM is also insured. This means the interest and principal are guaranteed to be paid. And I'm not the only who feels secure. My colleague Amy Calistri recently added this fund to her Daily Paycheck portfolio.
2. Black Rock Municipal Bond Investment Trust (NYSE: BIE)
Launched in 2002, this municipal bond fund invests in fixed-income markets in the United States. It's well diversified across the space with investments in hospitals, water, sewer, education, tax, housing, lease, power, tobacco, transportation and industrial pollution control sectors. It yields roughly 5.5%, which is equivalent to an 8.5% taxable yield for investors in the 35% tax bracket.
Risks to Consider: It's critical to note that the capital gains from distributions or from the sale of a bond are still subject to taxes. The new 3.8% Obamacare tax, for example, does not include income earned from municipal bond interest. Therefore, if you are dependent on fixed income, then this fact alone could influence your decision to allocate additional funds into municipal bonds as part of your tax-advantaged portfolio.
Action to Take --> The personal investment value of municipal bond funds is directly related to your tax bracket. If you are in the 15% bracket, then it makes little sense to accept the lower yields of municipal bonds. However, from tax brackets of 25% and up, municipal bonds increasingly make sense. Always be certain to consult a professional tax advisor prior to making any investment decisions.