Tax-Free Bonds

At first glance, stocks seem to have an advantage over bonds when it comes to taxation. Bond interest payments are taxed as ordinary income, so rates can be as high as 35% -- more than double the maximum 15% levy on stock dividends.

But bond investors have an escape not available to stock owners. They can buy municipal bonds and pay no federal taxes at all on the interest. And if you buy muni bonds from in-state issuers, you can avoid state and local taxes as well. (Retirees take note: Nontaxable interest is included in the formula to determine how much of your Social Security benefits is taxed.)

The stated yields of bonds issued by state and local governments and their agencies are usually lower than those of comparable government and corporate bonds. But if you're in a high tax bracket, that shortcoming disappears.

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A 4% yield on a muni is the equivalent of a 5.6% payout on a taxable bond if you're in the 28% tax bracket and 6% if you're in the 33% bracket. And these yields are relatively safe. Muni defaults have been rare over the years.

Even so, investors have been deserting munis and piling into ultrasafe Treasuries lately, as the subprime-mortgage crisis has stirred uncertainty in the bond market. Triple-A-rated general obligation muni bonds maturing in ten years recently yielded 3.4% on average, according to Standard & Poor's. That's equivalent to a taxable 5.4% if you're in the 33% bracket.

If you're shopping for individual munis, be extra careful if a triple-A rating comes as the result of insurance purchased by the issuer. Some of the top bond insurers could see their own credit ratings downgraded because of potential liabilities they face from insuring troubled mortgage securities. Such downgrades could slash the market value of the muni bonds they've insured.

So consider issues that earned their rating without the help of insurance, such as California G.O. bonds, which are rated A+ by Standard & Poor's and A1 by Moody's. California bonds maturing in 2034 (and callable beginning March 2016) recently yielded a tax-free 4.9%. And if the economy turns down, general obligation bonds -- which are backed by a government's taxing power -- are safest.

If you're unsure how to navigate the muni market yourself, consider a mutual fund, such as Fidelity Intermediate Municipal Income (FLTMX; 877-208-0098), a member of the Kiplinger 25. It boasts a low expense ratio of 0.43%, is run by an experienced management team and recently yielded 3.4%.

Bond investors have one other tax-saving option beyond munis: two rare tax-free corporate bonds issued by GMAC in the 1980s before a change in the law shut the door on similar issues. Both are zero-coupon bonds, which means they pay no current interest but sell at a big discount to face value. With other kinds of corporate and Treasury zeros, you have to pay taxes yearly on so-called phantom income. With the GMAC zeros, no taxes are due until the bonds mature or are sold.

The GMAC zero maturing in 2012 recently sold for $490, for a yield to maturity of 15.2%. The other issue, which matures in 2015, sold for $400, for a yield of 12.7%. Both bonds mature at $1,000 -- assuming GMAC doesn't default. "They are cheaper than dirt for someone willing to take the risk," says Marilyn Cohen, president of Envision Capital Management, a bond advisory firm in Los Angeles, noting their below-investment-grade credit ratings. Note, too, that GMAC could call in both issues at any time.

The joys of tax-free interest

Municipal bonds generally yield less than taxable bonds of similar maturity and quality. But that's before taking into account the tax-free status of municipal interest. Below, we compare the after-tax return on the average insured, triple-A-rated, ten-year muni, which yielded 3.43% in mid January, with that of ten-year Treasury notes, which yielded 3.83%. The higher your tax bracket, the bigger the savings.

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