| Bonds
provide an important component of many financial
plans, however there is the sticky matter of taxes you
must address.
Most investors buy bonds for two
basic reasons: Safety and/or income. Bonds can provide
some stability for your portfolio to counter the
volatility of stocks while generating current or
future income.
If you own stocks, you don’t
pay taxes on their growth until you sell and then at
the capital gains rate. Even dividends receive special
tax treatment.
Taxing Situation
Bonds on the other hand may face
immediate taxes, since you receive income usually
twice a year. Here’s how the tax situation breaks
down per bond type:
* U.S. Treasury issues –
These notes and bills generate federal income tax
liability, but no state or local income taxes.
* Municipal Bonds –
Municipals or munis are free of federal income tax and
if you buy them in the state where you live, are free
of state and local taxes.
These are sometimes called
“triple free.”
* Corporate Bonds –
Corporate bonds have no tax-free provisions.
* Zero Coupon Bonds –
Zero coupon bonds are sold at a deep discount and pay
no annual interest. The full face value is paid at
maturity. However, the IRS computes the implied annual
interest and you are liable for that amount even
though you don’t actually receive it until the bond
matures.
Guidelines
These are the general guidelines
for bonds and taxes. As you can see, municipal bonds
are the best tax deal. Of course, the yield on munis
reflects this benefit.
Investors don’t typically look
to bonds to outperform stocks, although this happens
from time to time. The main functions of bonds in a
portfolio are stability and income.
There is a quick and dirty way
to look at how a municipal bond compares with a stock
on an after-tax basis (which, after all, is the only
basis that matters).
Do the Math
To compute the taxable
equivalent of a municipal bond’s return, use this
formula:
Figure your marginal tax rate
(what you pay on the next dollar of income) and
subtract it from the number 1. Then divide a muni
yield by the result to get the taxable equivalent.
For example, if you were in the
30% tax bracket and considering a muni with a yield of
4.5% the calculation would look like this:
0.045 / (1 –
0.30) = 6.4%
This muni would give you the
same effective return as a taxable security paying
about 6.4%. If you add in state and local taxes, it
could push your taxable equivalent return to 7.5% or
so.
Considering the S&P 500 is
up about 6% for the first 11 months of 2004, this muni
looks like a pretty good deal.
Conclusion
Of course, stocks have always
out performed bonds over the long term, however if you
are looking for relatively secure income at a
reasonable return, municipal bonds are worth a look
for their tax benefits.
The
purpose of this newsletter is to stimulate thought for
my clients and those
professionals
with whom I network. If you are a real estate,
estate planning, taxation,
financial
planning or insurance professional receiving this
newsletter, please call my
office
and introduce yourself to me. I'm always seeking
to grow my referral network and
expose
more service professionals to my client base. I
specialize in helping those
individuals
looking to buy, sell or refinance real property in the
Pacific Northwest area. |
