Attention Tax-Ladened Investors

Klotz on Bonds

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<h3>James A. Klotz</h3>

James A. Klotz

Have you slogged through your taxes yet?

If so, you understand just how dramatically the landscape has changed. If not, brace yourself: taxes went up, mostly for the highest earners, but also for people with more modest means.

Higher taxes, of course, put into sharp relief the importance of knowing your after-tax returns, though just how important will likely astonish you.

Uncle Sam wants more

The tax hikes, as noted by CNNMoney, can be attributed to last year’s Congressional deal to avoid the “fiscal cliff” as well as provisions in the Affordable Care Act.

For the highest earners, the top income-tax rate was boosted from 35% to 39.6%, while tax rates on dividends and long-term capital gains rose to 20%, from 15%, for investors with taxable income of more than $400,000, or $450,000 for married couples.

There was also an increase in Medicare taxes. Taxpayers will pay another .9 percentage points of Medicare tax on wages of more than $200,000, or $250,000 if married, in addition to the 1.45% Medicare tax they’re required to pay on all of their wages, or 2.9% for the self-employed.

There is also a new 3.8% Medicare tax on net investment income that affects some or all of taxable capital gains, dividends, interest, rental income and annuities.

Additionally, Congress imposed some limits on deductions.

Higher taxes and you

What does this mean for your investments?

Let’s say you’re a California resident. According to figures by Bloomberg, if you’re among the highest earners – that is, you’re paying the highest federal and state income-tax rates, plus the 3.8% Medicare surcharge – your tax rate would be 50.83%. In New York, it would be 48.73%, and 45.25% if you’re a Pennsylvania resident.

For income investors seeking attractive returns, those eye-popping tax rates will require stratospheric pre-tax yields.

For example, high quality long-term munis are currently yielding between 4.50% and 5.00%. To equal that 4.50% return, investors in California would need taxable bonds that yield 9.15%. New Yorkers would need 8.78%, while Pennsylvanians would be on the lookout for instruments yielding 8.22%. (Figures for all states are listed below. Our chart assumes a tax-free bond yield of 4.50%.)

When the tax increases were originally discussed, the full impact of Uncle Sam’s elevated appetite did not immediately register with the majority of investors. Now that the tax ramifications have hit home, interest in the muni market has surged.

Fact is, no other financial instrument offers a similar level of security and return. Consequently, munis have outperformed other fixed- income markets in recent weeks.

The good news for investors is that significant opportunities remain.

James A. Klotz

President

James A. Klotz is the President of FMSbonds, Inc.
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Feb 24, 2014

Please note that all investing entails risk. Fixed income securities are subject to risks that will affect their value prior to maturity. Some of these risks can be related to changes in market conditions, issuer creditworthiness, and interest rates. This commentary is not a recommendation to buy or sell a specific security. All references to tax-free income refer to U.S. federal income tax. Income earned by certain investors may be subject to the Alternative Minimum Tax (AMT), and or taxation by state and local authorities. Please consult with your tax professional prior to investing. For more information on these topics please click on the “Bond Basics” link below or search by keyword at the top of this page.