Why Tax Free Municipal Bonds are Great Investments in Obama’s America

When President Obama was elected, the political tide began to lean in a direction that no longer favored the wealthy. The emphasis moved award from President Bush’s idea of an “ownership society” and moved toward benefiting the lower and middle class. Whether one agrees with the president’s politics or not, there are some new realities that investors will need to face in the coming years and adjust their portfolios accordingly.

Under a newly announced deficit reduction plan, the Obama administration is hoping to curb the annual budget deficit by “winding down the Iraq war” and by allowing some of President Bush’s tax-cuts to expire. Specifically, President Obama is hoping to repeal the dividends and capital gains lapse after the year 2010 for individuals who make more than $250,000 per year. This means the top rate for income tax would increase to 39.6% and the top rate for capital gains and dividends would rise to 20%. President Obama is also proposing that hedge funds and private equity partners be taxed at ordinary income rates rather than at capital gains rates.

How can investors adjust to these tax increases? Many are suggesting that tax-free municipal bonds are looking increasingly favorable to investors that make high-incomes. A tax-free municipal bond fund is essentially a group of investors that get together to form a mutual fund and then invest only in government debt in the form of municipal bonds. Essentially, they are loaning money to local, state, and federal governments and receiving their money back as interest. Since the government wants to encourage people to loan money to the various levels of government, money earned on these types of investments aren’t taxable.

There are different types of municipal bond funds that are usually separate by the length of the investment. Typically, there are short, intermediate, and long term municipal bond funds. Short term investments are typically bonds that are from six months to one year and are considered very safe. Long term municipal bonds can be over 5 years long and are considered a bit riskier, but also provide a higher interest rate in the long term.

How do municipal bonds compare to other investments? In the last year, they have performed spectacularly. All of Vanguard’s municipal bond funds have actually made money, where as the S&P 500 and the Dow Jones industrial Average are down over 40%. However, the last 12 months have been some of the most unusual in history. Since 1977, Vanguard’s Long Term Tax Exempt Municipal Bond Fund has averaged 6.04%. If you are at the top 35% tax bracket, this has a taxable equivalent yield of 9.3%. If the top tax bracket jumped up to 39%, that would jump up to a taxable equivalent yield of 9.9%.

Municipal bonds aren’t right for everyone, but if you’re in the 28% tax-bracket or above and need a relatively safe place to put your money, they’re definitely worth checking out. They’re not without some risk, but they’re a lot less turbulent than the stock market is currently.