Money Matters

December / January, 2012

Municipal Bonds for High Tax Brackets

By Kristi Sullivan

Is stock market volatility keeping you up at night? Are you worried about potentially rising taxes in the face of government debt and depressed at the low interest rates on your savings and bonds.

If so, the municipal bond market might be something to try. A municipal bond is a debt security issued by a state or local government to finance capital investments like water treatment, highways and airports. The interest on muni bonds is exempt from federal income taxes; and, if you live in the state issuing the bond, state income taxes as well.

By contrast, the interest on bonds issued by corporations or the federal government is included as income on your federal and state tax return. So, those in a higher tax bracket might find that tax-free interest attractive.

What about risk? Every article you read threatens cuts to education, police services and even streetlights to balance strained city and state budgets. Are muni bonds a safe investment?

According to Franklin Templeton Fund, municipal bankruptcies have been rare (only 600 since 1937). States are not allowed to file for bankruptcy under U.S. Bankruptcy code because they can have the following recourses available: increase taxes and fees and reduce services, lay off workers and renegotiate employee union contracts. By failing to honor their bond commitments, municipalities would be unable to borrow at reasonable cost in the future, so they will do just about anything to avoid that outcome.

Also, the recent risk seems to be overblown by the media outlets. Morningstar's Miriam Sjoblom points out that in 2011, municipal defaults are trending down from past years.

For perspective, Fitch Ratings did a study in 2003 of muni bond defaults between 1986 and 2002. Investment grade muni default rates were around .24 percent to .70 percent of all debt issued. And the recovery rate (how much principal you get back after default) was 100 percent. Default in the muni bond world generally means that interest doesn't get paid.

You can invest in municipal bonds through mutual funds or by purchasing individual securities. Never buy munis in an IRA account (you won't get the advantage of the tax-free interest in a tax-deferred or tax-free account). If you are in a lower tax bracket, corporate debt or treasuries could be better for you.

Kristi Sullivan is the founder of Sullivan Financial Planning, LLC, a Registered Investment Advisory Firm. She holds the Certified Financial Planner™ designation, Colorado Life and Health Insurance License and NASD Series 65 license. She's been helping individuals and families plan for their futures for 13 years. Reach her at 303-324-0014 or kristi@sullivanfinancialplanning.com.