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The Tax-Smart Answer to Low Interest Rates

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With April 15 fast approaching, many people look for ways to cut their taxes both now and down the road. If you're among the millions of investors who need to get regular income from their investment portfolios -- and aren't getting enough right now -- then there's one investment you should be looking at closely to see whether it belongs in your investing strategy: municipal bonds.

Why bonds get a bad rap
Most tax-sensitive investors learn early on that bonds aren't always the best investment from a tax standpoint. Although situations sometimes arise in which bonds produce significant capital gains -- such as the rebound from last year's financial crisis -- the bulk of your profits from bonds will more often come from the regular interest payments you receive.

That may not sound so bad, since it means that bond income is more predictable -- and typically less volatile -- than what you get from stocks in the form of dividends and capital gains. But that predictability comes with a price: The interest that bonds produce gets taxed at your full ordinary income tax rate, while both capital gains and dividend income currently enjoy significantly lower preferential rates.

For that reason, many advisors recommend putting most bonds in tax-favored accounts like IRAs. Yet a unique type of bond doesn't need that kind of protection.

Understanding municipal bonds
Bonds issued by state and local governments, known collectively as municipal bonds, enjoy tax advantages that other bonds don't. The interest from municipal bonds is exempt from federal income tax. Moreover, if you buy municipal bonds issued within a state where you owe income tax, the interest from those bonds is also free of state income tax there.

In comparing yields of municipal bonds with other types of bonds that don't enjoy the same tax benefits, you must include the impact of tax-free interest. For instance, 10-year Treasury bonds currently pay a yield of about 3.8%, while the typical 10-year municipal bond carries a yield of 3.35%. Just looking at those numbers, you'd conclude that the Treasury was slightly more attractive. But if your combined state and federal tax rate is 40%, then the municipal bond's yield is equivalent to a taxable rate of nearly 5.6%.

That doesn't just beat the pants off Treasuries. It tops yields on top-rated AAA bonds from issuers such as Microsoft (Nasdaq: MSFT  ) and Johnson & Johnson (NYSE: JNJ  ) . It's also competitive with yields on corporate bonds from single-A rated issuers like Morgan Stanley (NYSE: MS  ) and Goldman Sachs (NYSE: GS  ) . And it even gets close to what you can earn on higher-yield corporates from lower-rated issuers like Discover Financial's (NYSE: DFS  ) Discover Bank unit.

Even if you're used to getting your income from dividend stocks, you'd need a pre-tax yield of 4.8% to equal the after-tax return on 10-year muni bonds. Only a few dozen large caps, such as Altria Group (NYSE: MO  ) and Southern Company (NYSE: SO  ) , currently top that yield.

The tradeoff
Just like any other investment, municipal bonds don't come without risk. Given the turmoil that state and local governments have faced lately, you can't take the financial stability of even government institutions for granted. Moreover, if interest rates rise, then like any other bond, munis will drop in value.

At today's yields, however, you may well be getting full compensation for the risk you're taking on. Unlike with stocks, which require a company to thrive and continually increase profits to truly create a successful investment, investors in bonds only need to see issuers survive long enough to make their interest and principal payments.

If you're frustrated by the current low yields on most investments, and you want to take steps toward cutting your tax bill, take a closer look at municipal bonds. Although you shouldn't assume that munis are risk-free, you might find that their tax benefits earn municipal bonds a place in your fixed-income portfolio.

Looking for other ways to cut your taxes? Check the Motley Fool's Tax Center for money-saving tips.

If you need more help getting your taxes under control, you might benefit from consulting an independent financial planner. The Garrett Planning Network is offering a limited-time 10% discount for new Motley Fool clients. Just click this link, search your state, and look for the Motley Fool icon to identify participating advisors.

Fool contributor Dan Caplinger is looking forward to the tax post-season. He owns shares of Altria Group. Discover Financial and Microsoft are Motley Fool Inside Value selections. Johnson & Johnson and Southern Company are Motley Fool Income Investor recommendations. Motley Fool Options has recommended buying calls on Johnson & Johnson and a diagonal call position on Microsoft. Try any of our Foolish newsletter services free for 30 days. Stay street-smart with The Fool's disclosure policy.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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9/15/2014 4:02 PM
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