Some Retirees Need to Rethink Municipals

It’s no secret that the economic plan signed into law by President Clinton last month has been a boon to companies selling municipal-bond mutual funds.

Whenever tax rates rise, investments that pay tax-sheltered interest become that much more attractive. And muni-bond fund sales so far this year are running 42% higher than in the comparable period of 1992.

But less attention has been paid to the fact that the tax change actually diminishes the appeal of muni-bond funds for at least one group of investors: middle-income retirees.

Why? Because under the new law, up to 85% of a person’s Social Security benefits may be taxable starting next year, compared to the current maximum of 50%.

And muni-bond interest, though nominally tax-free, can help push people into income levels where the taxes apply to more of their Social Security.

“People will need to determine whether their muni income is a cause of their Social Security becoming taxed,” says Harvey Gettleson, a tax partner at Ernst & Young in Century City. “Some people may be better off with alternative investments paying a higher (taxable) yield,” he says.

To determine whether your Social Security benefits are taxable, you need to calculate your “provisional income.” This includes adjusted gross income, interest from municipal bonds or bond funds, a portion of Social Security benefits and a few other items.

Another, more complex calculation is then needed to determine how much of your benefits are taxable.

The new provisional-income thresholds, above which 85% of benefits may be taxable, will be $34,000 for individuals and $44,000 for married people filing joint returns.

Up to 50% of benefits may be taxed for Social Security recipients having provisional income above $25,000 (single) and $32,000 (married), as is currently the case.

As noted, the tax changes affecting Social Security benefits take effect next year.

As complicated as all this may seem, the rules for judging the value of muni-bond funds are pretty straightforward:

* If you’re comfortably above the higher income thresholds, your Social Security benefits will be taxable anyway. So muni-bond funds won’t hurt you from a tax standpoint. In fact, they will help.

“With the general increase in tax rates for people in higher income brackets, munis remain attractive,” says Gettleson.

* Assuming your income comes in below the $25,000 and $32,000 thresholds, you probably don’t need much tax shelter, especially if you fall in the 15% marginal bracket.

So you might consider avoiding municipal securities altogether, Gettleson suggests, as they pay lower yields than are available on government or corporate bonds.

That sentiment is shared by Zane B. Mann, publisher of the California Municipal Bond Advisor, a newsletter based in Palm Springs.

“Muni investments aren’t appropriate for anyone who’s not in the 28% bracket or higher,” he says.

* Only if your income is near or between the threshold amounts do you have some figuring to do, assuming of course that muni-bond funds interest you in the first place.

Considering the heavy demand for tax-free interest, coupled with the general trend to lower interest rates, muni-bond funds have been superb performers of late.

From January through August, national muni-bond portfolios generated an average total return--including both interest and appreciation--of 9.7%, according to Lipper Analytical Services.

Funds that invest exclusively in California municipals have fared even better--up 10.1% over the eight-month period.

Chip Norton, editor of IBC/Donoghue’s Bond Fund Report, a newsletter in Ashland, Mass., predicts that muni funds will continue to offer good performance at least into early 1994 and possibly well into 1995.

“We don’t see the market turning in the near term,” he says, considering that inflation and interest rates are down in response to the sluggish economy.

But Mann is more wary, considering that muni-bond funds have already been on a sustained rally.

“You would be buying at the highest levels they’ve ever been at,” he says.

Mann recommends that new investors seeking tax-free interest compromise by purchasing intermediate-term muni funds instead of the more common long-term variety. Because the intermediate portfolios hold bonds coming due sooner--typically within five to 10 years--they pay slightly lower yields but are less volatile.

Muni Funds on a Roll Sales of municipal bond mutual funds are headed for a record year in 1993, thanks to continuing low interest rates and President Clinton’s push for higher income taxes.