Q. I'm at a loss to understand how municipal bonds work. In January 2003 I was advised to invest in a municipal bond fund that specialized in short term bonds. Now, almost three years later, I've barely seen any gains in my quarterly reports. Sometimes, the report shows that I've lost money. Other times, it shows a small gain. Meanwhile, the management firm takes about $1,200 in yearly fees.
My financial adviser says this is to be expected because none of the bonds have matured this year and because the fund keeps shifting its investments. About 5 percent of the bonds will mature in less than a year, 33 percent in one to two years, and 62 percent in 2 to 5 years.
Is my financial adviser right? Is it just a question of "staying the course" and waiting for the bonds to mature, or should I get out of this fund as soon as possible?
--R.S., by email
A. Investing short term, whether it was in tax free or taxable bonds, hasn't been a very good play in the last three years because the Federal Reserve has been increasing the only interest rates it can change--- short term rates. As a consequence, the net asset value per share of short term bond funds has tended to decline as the yield on short term securities has risen.
As a practical matter, while short term bond funds have performed relatively poorly compared to long or intermediate term funds, your adviser was probably trying to protect you from the greater damage that can occur to long term bonds when (and if) interest rates rise.
Q. My wife and I are retired and debt-free. The three sources of our income are our state's teacher retirement system, municipal employees' retirement fund, and Social Security. We are approaching the age of mandatory IRA withdrawals. We would like to place these funds where we would not have to pay taxes again, and begin to draw tax-free earnings.
Our thoughts are to build a 5 to 8 year municipal bond ladder, or to purchase shares in municipal bond funds of various maturities. With the bonds we would pay a broker mark-up but receive full principal at maturity. With the funds we would pay small fees but lose principal if we had to sell at a lower price than our purchased price. What do you suggest?
---R.P., by email from Des Plaines, IL
A. To do this right you'll probably need the advice of a good tax accountant. It is very likely that you face a tax trap. Tax-free bond income is one of the sources of income that must be counted when you are figuring whether your Social Security benefits are taxable. As a consequence, you could have tax-free municipal bond income that would still work to increase your federal income tax bill because each dollar of interest could trigger the taxation of 50 cents to 85 cents of Social Security benefits.
If you want to complain about this, direct your complaints to the Republican and Democratic parties. The Republicans put the tax in place. The Democrats increased it.
As an alternative, you may want to try a "Plan B", again in consultation with a good tax accountant. If you truly only want to pay taxes once, you should look into doing a Roth-IRA conversion. You'll pay ordinary income taxes on withdrawal, but once the IRA money is in a Roth IRA, you'll have complete freedom in making withdrawals. And all withdrawals will be tax-free.
Conversion would allow you to earn higher yields in taxable securities but avoid taxation on any withdrawals.
Are there any pitfalls? Of course! You can't make withdrawals from a Roth for 5 years without paying a penalty. That's a good reason to start the Roth conversion now, before mandatory withdrawals.
Scott Burns is the retired Chief Investment Officer of AssetBuilder, the creator of Couch Potato investing, and a personal finance columnist with decades of experience.