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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.
One should consult with a qualified tax professional prior
to implementing any tax strategies.
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