A Tax Shelter And Then Some - Mutual Funds

Kiplinger's Personal Finance Magazine, Nov, 2000 by Brian P. Knestout

FUNDS -- In-state MUNICIPAL BONDS offer juicy yields to high-bracket investors.

LET'S BE frank: Municipal bonds are yawners. But munis are also one of the last great tax shelters, generating income that is usually exempt from federal income tax. And if you live in a high-tax state, such as California or New York, the generosity of the tax law goes even further. Income from a muni issued in your home state is almost always exempt from state income taxes. If you're subject to a local tax, the income may be exempt from that, too. (Keep in mind, however, that any profit made from selling a muni isn't exempt, but is taxed as a capital gain.)

Individual munis can be tough to research and buy. Investing in a mutual fund that owns muni bonds in your state is a better way to garner double or triple tax exemptions on your current income. And, of course, by investing through a fund, you obtain diversification among a variety of issuers and gain an extra measure of safety.

Tax-free or taxable?

TO DETERMINE whether the after-tax yield you'll get from a tax-free bond is better than a comparable taxable bond, simply divide the tax-free yield by 1 minus your marginal federal tax rate (expressed as a decimal). So, if you're in the 31% tax bracket, a tax-free bond fund yielding 5.2% is equivalent to a taxable bond fund yielding 7.5% (5.2 divided by 0.69). For someone in the top federal bracket, 39.6%, that same 5.2% yield would equal 8.6% from a taxable bond (5.2 divided by 0.604).

Calculating the additional state-tax benefit you'll get is a bit more complex, because your state income tax is deductible on your federal tax return if you itemize. For example, if you live in Oregon and are in the top federal and state brackets (39.6% and 9%, respectively), you'd deduct 39.6% of 9%, leaving you with an effective state-tax rate of 5.44%. Add that to your federal tax rate and your top tax hit is 45.04%. So, for Oregonians, that local bond yielding 5.2% equals a taxable bond yielding 9.5%.

Where munis make sense

CLEARLY, in a high-tax state--California, Minnesota, New Jersey, New York and Oregon all have top rates above 6%--it makes sense to consider in-state munis.

The risks? If interest rates rise, your bond fund's price is likely to fall. And an issuer might default, although that occurs infrequently. To protect yourself, you can invest in funds that own only bonds that are insured against default. They usually yield a bit less than similar uninsured bonds.

You should also be aware that some munis are taxable for high-income investors who are subject to the alternative minimum tax (AMT). If your fund owns bonds that are used to finance projects with a connection to private activities, such as amusement parks, stadiums and even single-family housing developments, part of the fund's interest may be subject to the AMT.

There are literally hundreds of single-state muni-bond funds. Below, we identify five attractive funds--one for each of five high-tax states. We looked for funds that offer investors good overall credit quality, lower-than-average expenses and no sales fees. All sport long average maturities.

* Safeco California Tax-Free (recent 30-day annualized yield, 4.8%; one-year total return to September 1, 8.3%; call 800-624-5711 for a prospectus). Manager Steve Bauer buys bonds with long maturities (the average is 25 years) at a discount. That boosts the yield but makes the fund more susceptible to interest-rate changes. The fund has a high concentration of hospital and housing bonds, and avoids AMT bonds.

* Sit Minnesota Tax-Free Income (5.6%; 2.5%; 800-332-5580). Managers Michael Brilley and Debra Sit prefer high-yielding revenue bonds (bonds that lay claim to a specific type of revenue generated by the issuer, such as highway tolls) and shy away from insured bonds. The two research each bond vigorously. "We've visited virtually every project in which we own a bond," says Sit. A third of the portfolio is in bonds rated BBB, the lowest rung of investment-grade bonds, while most of the remainder are rated A or better. The fund owns some AMT bonds.

* Vanguard New Jersey Insured Long Term Tax Exempt (4.9%; 7%; 800-635-1511) and Vanguard New York insured Long Term Tax Exempt (4.9%; 7.6%). Both follow the same basic investing principles and invest primarily in insured bonds. Ian MacKinnon, head of Vanguard's Fixed Income Group, determines the interest-rate and maturity strategies for both funds. The New Jersey fund, run by Christopher Alwine, and the New York fund, managed by Christopher Ryon, target bonds issued for such necessary projects as hospitals and water and sewer systems. They can each place up to 20% of their funds in AMT bonds. Credit quality is topnotch. As is common with Vanguard bond funds, they benefit from an ultralow expense ratio of 0.2% a year.

* Columbia Oregon Municipal Bond (4.7%; 5.8%; 800-547-1707). Taking an eclectic approach, manager Greta Clapp looks for the cheapest bonds she can find while maintaining high credit quality (the bonds in the portfolio have a double-A rating, on average). More than a third of the portfolio is in insured bonds. To boost yield, Clapp will buy AMT bonds if their yields are generous enough. She's also fond of unrated bonds because "they come quite a bit cheaper than rated paper, but their comparative credit quality is still very good," she says. Unrated bonds recently represented 8% of the portfolio.