|
Taxes are, alas, going up.
On December 31, 2010, the Bush tax cuts are set to expire.
The Obama administration, which has pledged to eliminate tax
cuts for the wealthy, has said it intends to let the tax
cuts expire for the highest brackets.
The result:
The two top tax brackets will increase from 33% to 36% and
from 35% to 39.6% by the end of 2010. Interest earned on
many bonds, funds and other income investments -- anything
deemed "ordinary" income and subject to a taxpayer's
marginal rate -- will be subject to the higher taxes.
Tax rates for dividends will be raised to 20% from the
current 15%.
The portion of income many investors actually keep will be
reduced, and Uncle Sam's portion will increase.
But, there's an alternative: Municipal bonds.
The beautiful thing about municipal bonds is that interest
is tax-free at the federal level and is sometimes exempt
from state and local income taxes, too. And municipal bonds
are the only place investors can find the one kind of yield
that actually rises when tax rates go up: Tax-equivalent
yield.
The tax-equivalent yield, for the sake of comparison, adds
back income taxes that were never owed. The higher
"tax-equivalent" yield on the taxable investment is the
return an investor would have to earn to equal the tax-free
yield.
Consider an example.
Assume an investor in the 35% bracket earns 5% from a $10,000
tax-free municipal bond investment:
|
Tax-Equivalent Yield, Example No. 1: Tax-Free Bond |
|
Principal invested: |
$10,000 |
|
Interest earned: |
$500 |
|
Tax bracket: |
35% |
|
Tax due: |
$0 |
|
Net interest: |
$500 |
|
Gross
yield: |
5.0% |
|
Tax-equivalent yield: |
Unknown, or "X" |
To determine the tax-equivalent yield X,
divide the tax-free-yield by 1 minus your federal tax
bracket. Using the above information, that calculation would
look like this:
X = 5.0% / (1 - 0.35)
X = 5.0% / 0.65
X = 7.69%
The formula tells us that a 5% yield to an investor in the
35% tax bracket is a tax-equivalent yield of 7.69%.
That means that the return from a corporate bond, for
example, would have to be 7.69% to equal the tax-free
return.
Don't take my word for it. Let's check it out:
Here, again, is the chart from above, with a $10,000
taxable investment:
| |
Example 1: Tax-free |
Example 2: Taxable |
|
Principal invested: |
10,000 |
$10,000 |
|
Interest earned: |
$500 |
$769 |
|
Tax bracket: |
35% |
35% |
|
Tax due: |
$0 |
$269 (0.35 times $769) |
|
Net interest: |
$500 |
$500 ($769-$269) |
|
Gross yield: |
5.00% |
7.69% |
|
Tax-equivalent yield: |
7.69% |
-- |
As taxes rise, so do tax-equivalent yields on municipal
bonds. Mr. Obama's tax policies will have a sure and certain
effect: The relative value of municipal bond yields will
soar as rates rise.
This presents an opportunity for income investors.
The Western Asset Municipal High-Income Fund (NYSE: MHF,
$7.35) is a closed-end municipal bond fund that invests
in tax-free municipal bonds issued by states, cities and
local governments throughout the United States. The
closed-end fund pays a tax-free income of $0.037 each month,
or $0.444 a year -- a 6.0% yield that is exempt from federal
taxes.
The chart at the
right shows the current U.S. tax brackets for
couples filing jointly, as well as the
tax-equivalent yield for the Western Asset
High-Income Fund.
If a couple earned $180,000 for the year, they would
be placed in the 28% tax bracket. Their return on
MHF would be a tax-equivalent 8.47%, a
yield that far exceeds what most companies and even
many trusts are able to pay. |
|
Income |
Tax bracket |
Tax-equivalent
yield |
|
$0-$16,700 |
10% |
6.78% |
|
$16,700-$67,900 |
15% |
7.18% |
|
$67.900-$137,050 |
25% |
8.13% |
|
$137,050-$208,850 |
28% |
8.47% |
|
$208,850-$372,950 |
33% |
9.10% |
|
$372,950 or more |
35% |
9.38% |
|
Closed-end funds are one of the best ways to
get tax-free income. Unlike an individual bond, these funds
are highly liquid. They're also easy to trade.
Individual investors can buy or sell fund shares through any
full-service or discount broker any time the market is open,
just like a stock.
A closed-end fund can do a lot of things most investors
can't do on their own. A fund employs a team of experts to
scour the market for the best deals. Their institutional
buying power enables them to find the best prices,
and, hence, the highest yields. Plus, fund investors
have automatic diversification. The Western Asset Municipal
High-Income Fund, as of April 30, owned 112 bond issues
throughout the country. This diversification lowers the risk
associated with an individual bond.
This fund also pays monthly, where as most bonds pay twice a
year. Because a fund owns many bonds with various payment
schedules, it can make interest payments every month.
Investors can choose from 159 national tax-free closed-end
funds with a 6% yield or higher. What's so great about MHF?
1. Leverage. The overwhelming majority of these funds
use leverage -- that is, they borrow money. MHF does not.
There's no performance loss. The fund still offers a yield
that is competitive with leveraged funds. MHF's debt-free
balance sheet makes it far safer than its competitors.
2. Management. The fund is run by Western Asset,
which has managed municipal-bond portfolios since
1971. Management employs a team approach: Different experts
manage individual sectors. These managers tend to buy the
good stuff: As of June 30, the average credit quality in the
portfolio was above investment grade, at BBB+.
3. Performance. This fund has been solid. Even
without leverage, MHF has wound up in the top quarter of its
peer group for the past three- and five-year periods.
4. Rising taxes. That means rising yields for municipal
bonds. Tax-free investments in high-earners' portfolios
stand to benefit most. The only thing better than a high
yield is a high yield you can actually keep.
Investors, regardless of their income-tax bracket, who
want to keep their returns rather than hand
them over to Uncle Sam ought to consider the safe,
well-managed, tax-free return available with MHF.
Good Investing!
--Tom Hutchinson
StreetAuthority Staff
P.S. If you're interested in shielding your wealth with
tax-free municipal bond funds, my colleagues have put
together an exciting list of muni funds for new
High-Yield Investing subscribers. They found a total of
44 muni funds yielding more than 6% that also trade below
the value of their assets.
Subscribe today and you'll receive this exclusive list.
|
