By Glenn Ruffenach
Last Update: 12:01 AM ET Jul 31, 2012
I hate to be a party pooper, but ... your federal taxes are likely to go up, possibly as early as January. If thats the case, you should begin taking a closer look at one of the most importantand, as of late, problematicinvestments for many retirees: municipal bonds.
First, taxes. As you probably know, the Bush-era tax cuts are set to expire at year-end. Even if theyre extended, tax increases have been built into health care reform. (Starting in January, taxpayers in higher brackets will see a new 3.8% tax on dividends, interest income and capital gains.) Even if that legislation is gutted, future efforts to pare budget deficits will likely translate into higher marginal tax rates.
What to do? One straightforward strategy is to reposition assets: Move investments taxed at higher rates into a tax-deferred account (like an IRA) and replace the holdings in taxable accounts with more tax-efficient products (like municipal bonds).
Leon LaBrecque, who heads LJPR, a wealth-management firm in Troy, Mich., offers an example: Lets say you have a stock with a 3.5% dividend and a tax-free muni paying 3%. Right now, the after-tax yields are roughly equal. In 2013, though, assuming tax rates return to 2001 levels, the after-tax yield of the stock will be 1.98% for an upper-bracket taxpayer, compared with the 3% tax-free yield on the muni bond.
Given the gridlock in Washington and the need for revenue at all levels of government, munis look good in most tax scenarios going forward, LaBrecque says. (President Obama has proposed reducing tax deductions on muni bond interest for high-wage earners, but most observers say the idea would face stiff opposition from local and state governments.)
Municipal bonds, of course, have long been a favorite of retireesa safe, predictable play. But therein lies the problem for investors seeking to buy products in the months and years ahead: Safety and predictability have given way to uncertainty and complexity.
Not long ago, says Matt Fabian, managing director at Municipal Market Advisors, a typical retail investor could assemble, without much difficulty, a nice collection of insured munis rated double-A or better with after-tax yields of 5% or more.
Today, insurance is all but nonexistent, yields are half what they were, top-quality bonds are in short supply, and stress on muni issuers is increasing. (Moodys currently has a negative credit outlook for state and local governments as a group.) When I asked how, then, to navigate these waters, Fabian answered, more serious than not: You need a Virgil, referring to Dantes guide through hell in The Divine Comedy. And actually, thats a good place to start. (With Virgilnot with hell.)
If munis will play a larger role in your nest egg in the future, consider these steps:
Get a guide
Asking your financial adviser to be an expert in all things muni is asking too much. This is a $3.7 trillion market with 5,000 issuers and 1.5 million individual securities. You can, of course, turn to muni bond funds. But a better approach is tailoring a portfolio of individual bonds to your specific needs. That means working with a broker or firm that focuses on munisthat treats them as a core asset class, Fabian says. Check referrals; look for specialists; find your Virgil.
Have a plan
Ask yourself: What do I want out of a muni portfolio? Many people skip this key step, says Stephen Scott, who manages the Southeast municipal trading desk for Raymond James Morgan Keegan out of Atlanta. If you have a specific cash needsay, funding a grandchilds educationbonds with greater liquidity and shorter maturities may be a better fit. But if the goal is solely retirement income, then safety and longer maturities with the highest yield possible will likely move to the head of your wish list.
Hit the books
The most common mistake among muni investors? People simply dont understand what theyre buying, says Hugh McGuirk, head of municipal investments at T. Rowe Price. Someone will think they have a state of Maryland bondwhen its really a university bond in Maryland. The problem, in this case, is credit quality: Marylands general obligation bonds, McGuirk notes, are rated triple-A, but a university bond in the state could be as low as double-B.
Two online tools are invaluable: emma.msrb.org, run by the Municipal Securities Rulemaking Board, and investinginbonds.com, created by the Securities Industry and Financial Markets Association. Both give information about muni markets and individual bond offerings, and both have really leveled the playing field for investors of all stripes, says Marilyn Cohen, president of Envision Capital Management in Los Angeles.
Think cash flow
Yes, munis can be a big help with taxes going forward. But these investments are equally important for cash flow. A well-designed portfolio of high-quality individual municipal bonds will deliver a secure stream of payments that you can calculate almost to the penny, says Stan Richelson, coauthor of Bonds: The Unbeaten Path to Secure Investment Growth. Just add up the interest coupons that the bonds will pay twice a year. People always say, Bonds are too complicated, says Richelson, but most investors dont take the time to understand them. Do your nest egg a big favor: Take some time.