Spreading the Muni Advantage

By Tim Paradise
Associated Press
Sunday, September 24, 2006

NEW YORK -- Many investors have long viewed the tax advantages municipal bonds provide as largely benefiting the rich, who pay a higher tax rate. While it's true that investing in municipal bonds is a no-brainer for those in the upper brackets, it's also something for regular investors to consider.

"The mentality that it's only for the rich isn't right," said Jim Murphy, a portfolio manager at T. Rowe Price Group Inc.

Financial advisers say municipal bond funds can serve as a good means of diversification and prove to be a better investment than even some taxable bonds with higher yields. Murphy sees investing in muni funds as a smarter move than buying individual municipal bonds, in part because fund managers spend a good deal of time looking for the most efficient way to handle taxes that even municipal bonds can't avoid, such as capital gains taxes.

The fees investors can face with municipal bond funds are often less than what they would encounter if they were to cobble together bond portfolios on their own, Murphy said. Municipal bonds are priced at $5,000 apiece and increase in increments of that same amount.

While they cannot help investors avoid all taxes, the interest municipal bonds pay is usually free from federal taxes and generally free from state taxes if the bondholder resides in the state in which the bonds were issued. For this reason, investors who live in areas with high taxes can benefit even more, though there is often greater demand in those areas. Of course, investors in this debt, which is offered by government agencies to finance public works, must consider that municipal bonds typically pay lower yields.

Murphy would steer those in a "medium-size tax bracket," about 25 percent, to do some math to determine whether they would do well to hold municipal bond funds or taxable bond funds.

Finding a tax-equivalent yield allows investors to compare tax-free and taxable bonds. If, for example, an investor in the 25 percent federal tax bracket has a municipal bond with a yield of 4 percent, it would take a taxable bond yielding 5.33 percent to bring in the same income after taxes are factored in. Investors can also compare tax-free bond funds and taxable bond funds by using the taxable-equivalent yield.

The Vanguard Group offers a calculator on its Web site ( http://www.vanguard.com ). Search there for taxable-equivalent yield calculator.

"It's kind of a by-the-numbers decision," said Ellen Rinaldi, head of investment counseling and research at Vanguard. "If you're in the 10 to 15 percent bracket, taxable bonds are going to be a better arrangement."

Vanguard recommends those in the 25 percent tax bracket have their long-term bonds in municipal bonds, while those in tax brackets of 28 percent and above should have all their bond holdings in municipal bonds.

Some relatively well-off investors have turned to municipal bond funds as a way to avoid triggering the alternative minimum tax, which is meant for the rich but has ensnared more taxpayers in recent years because it doesn't adjust for inflation.

One area in which investors sometimes go astray, financial professionals warn, is by investing in municipal bond funds through a tax-deferred account such as a 401(k) plan. The tax shelter people are getting not only makes the tax benefits of municipal bonds unnecessary, but provides investors a lower yield than if they put taxable bond funds into their tax-deferred account.

"You don't want to put tax-free municipal bonds in that type of account," Mario DeRose, a fixed-income strategist at Edward Jones, said of tax-deferred investments. "Find the highest yielding bond because you do have that shelter.

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