Taxes may be going up – again – in the near future.
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Question: Do Tax-free municipal bonds have a place in your portfolio?
Answer: Generally, if your income tax rate, after deductions, is 25% or higher, you may be good candidate for tax-free bonds.
Question: What are my choices, when seeking tax-free income?
Answer: You have several choices:
DIY. This involves buying bonds from brokerage firms and doing all the research and monitoring for both credit quality and prices. Transparency can be challenging and markups are not disclosed, so you may significantly overpay. But at least there are no management fees and you can assemble a portfolio of individual bonds, each with a stated final maturity.
Traditional bond funds, which have much higher expenses, including management fees, than their exchange-traded fund (ETF)counterparts. Neither feature a stated final maturity, which can create significant financial planning challenges.
There is no guaranty of return of principal.
Some common ETFs target a certain time horizon, such as 10 years or 20 years, but this feature simply provides constant exposure to the performance the underlying bonds. The ETFs never actually mature.
Another choice is the separately-managed account (SMA). SMAs are individual accounts with individual bonds that have stated final maturities. This makes financial planning less challenging as you know exactly when a particular bond will mature.
This can eliminate the need to sell a bond fund or ETF in order to raise cash thus eliminating the risk of receiving less than you paid for it. Prices for bond funds as well as their ETF counterparts are in constant motion.
The knock on SMAs are the fees. And in the fixed-income arena, low fees are critical to your success. SMAs comprised of equities may help offset exorbitant fees with the next Tesla or Google, but bond portfolios lack this type of opportunity to attempt to compensate for high fees.
Finally, with all three of these choices, you will pay management fees as well as advisory fees tacked on, if you work with a financial advisor. Collectively, the annual fees can easily amount to 1.0% to 1.50%. Given today’s record low interest rates, the financial advisor and the SMA manager they select can make more money than you from your investment.
One sensible alternative is to work directly with a tax-free municipal bond manager-a registered investment advisor specializing in bonds. This at least eliminates the need to involve a financial advisor- the middleman.
Management fees alone can range from as little as 0.10% to upwards of 0.75%, depending on the account value and other factors.
For instance, my firm specializes in managed accounts of tax-free municipal bonds and our fees are on the lower end of this range. We keep our expenses down and pass the savings to our clients, who can hold their bonds at the custodian of their choice. We customize each portfolio and can avoid state income taxation as well as federal by creating a portfolio comprised of bonds issued in your particular state of residence.
Question: What about taxable municipal bonds?
Answer: Taxable municipal bonds are more prevalent now due to some recent changes in tax law pertaining to refunding or refinancing of bond issues.
Taxable municipal bonds can be a good choice for retirement accounts, including IRAs.
Have a question? Contact Ed Mahaffy.
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