Using Municipal Bond ETFs To Avoid Tax Hikes

by on March 5, 2013 | ETFs Mentioned:

Nothing rings more true than Ben Franklin’s famous quote, “In this world nothing is certain but death and taxes.” Looking past the morbid side of that statement, higher taxes are almost certainly coming in the next few years, regardless of who is in office, as local counties, states and the federal government all look to fill their dwindling coffers [see How To Take Profits And Cut Losses When Trading ETFs].

This year’s past “Fiscal Cliff” battle highlighted the budget struggles facing the nation. The country faces a debt dilemma and ultimately many Americans will be paying more in taxes in the years ahead based on the agreement reached to prevent the automatic spending cuts. However, those Americans in the top three tax brackets will be feeling the brunt of the cliff’s resolution.

Wealthier Americans will jump on their family income taxes and some will pay an Municipal Bondsadditional percentage on certain levels of investment income. Likewise, many filers will see their personal exemption and itemized deductions limited, and a variety of other measures in the fiscal cliff deal and in President Obama’s health care reform law will also raise taxes. Finally, tax hikes don’t just stop at the federal level, states such as New York and California will start generating revenues from new taxes on those earning $300,000 or more this year [see High-Tax Bracket ETF Portfolio].

The good news for investors is that there is a partial solution to all of this – municipal bonds.

As one of the best ways investors have to fight taxes, municipal bonds should be a serious portfolio contender. The bonds’ main appeal is the tax-free income. Munis are exempt from federal taxes as well as state tax in the state of issuance. By contrast, Treasuries are only free from state and local taxes. Generally, investors in the top three tax brackets will do better in municipal bonds rather than buying a similar treasury issue and paying the tax. Luckily, the boom in ETF issuance has made adding a swath of munis quite easy.

iShares S&P National AMT-Free Muni Bond (MUB, A+)

With roughly $3.7 billion in assets, the iShares S&P National AMT-Free Muni Bond (MUB) is the behemoth in the sector. The fund tracks the S&P National Alternative Minimum Tax Municipal Bond Index, which is a measure of the investment grade segment of the U.S. municipal bond market. The ETF holds approximately 2300 different IOUs from a variety of states with California and New York leading the way. Credit quality is good–as it tracks just investment grade debt–and the average weighted maturity is just less than six years.

The ETF has a distribution yield of 2.58%, which equals 3.96% for someone in the 35% tax bracket. That can provide some nice income for an investor looking to escape some of their tax burdens. Expenses run at 0.25% [see 101 High Yield ETFs For Every Dividend Investor].

SPDR Nuveen Barclays Capital S/T Muni Bond (SHM, A-)

Rising interest rates can wreak havoc on munis, just as easily as all other bonds. Given the fact that the Federal Reserve will eventually have to raise interest rates, playing the short end of the spectrum could be a prudent move. The SPDR Barclays Capital Short Term Muni (SHM) is the most active fund in this area.

The ETF tracks Barclays Managed Money Municipal Short Term Index, which follows investment grade bonds with maturities of one to five years. The fund currently has 383 different munis and an average maturity of three years. SHM’s yield leaves a little to be desired at 0.44%–or 0.67% for someone in the 35% tax bracket–but that yield should rise faster than MUB when the Fed finally raises rates. Expenses run a cheap 0.20%.

The iShares S&P AMT-Free Municipal Series

For investors who want the flexibility of owning individual bonds at a certain maturity date, plus the diversification benefits from owning a portfolio of muni bonds, iShares’ Municipal series is for you. Unlike, the previous two ETFs on this list, the funds in this series will not “roll-over” their bonds once they mature. Instead, when the fund hits its target date, investors will be paid cash for the value of the underlying bonds. Think of these as buy-and-hold ETFs. As such, trading volumes are pretty low [Download 101 ETF Lessons Every Financial Advisor Should Learn].

For example, the iShares 2016 S&P AMT-Free Municipal Series ETF (MUAE) will cease to exist in 2016, while the iShares 2013 S&P AMT-Free Municipal Series (MUAB) will close at the end of this year. Investors can use these products to hone in certain maturity levels, save for future expenses or reduce other funds’ average weighted maturities. Expenses for the funds in the series run 0.30%.

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Disclosure: No positions at time of writing.