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Tax-free munis could be capped

By Sheyna Steiner · Bankrate.com
Wednesday, September 14, 2011
Posted: 1 pm ET

President Obama sent his jobs bill to Congress this week. Among the spending cuts and tax increases is a provision to cap the amount of tax-exempt interest a high income investor can earn from municipal bonds.

Interest from municipal bonds is generally free from federal income tax, as well as state and local taxes in some cases. Because they are tax-exempt, muni bonds carry lower yields than taxable bonds but they can be a great tool for investors trying to manage their tax bill.

Because only high income investors are targeted, this provision in the American Jobs Act has come under fire as a covert tax on the wealthy.

Here are some of the details from a story on the Barron's Web site, Barrons.com, "Obama's jobs bill would hit munis."

Specifically, individuals earning over $200,000 and families earning over $250,000 would effectively have the value of tax breaks against the top 35% bracket lowered to the 28% bracket...

As with deductions, the tax-free feature on munis is more valuable to investors in the top income-tax brackets. For that reason, Internal Revenue Service data show that 58% of all tax-exempt income was earned by individuals earning over $200,000, according to The Bond Buyer, the muni-market trade paper.

For instance, a tax-free bond that yields 3.50% (about the going rate on a 30-year, triple-A muni) is equivalent to a taxable bond that yields 5.38% for an investor in the 35% tax bracket. But for an investor in the 28% bracket, that 3.50% muni is equivalent to a taxable yield of 4.86%.

This has caused a good bit of consternation this week, but not only for investors.

Bond issuers fear that any changes to tax exemptions could weaken demand for municipal bonds or start a tsunami of withdrawals from muni bond funds. Municipalities and institutions such as hospitals, utilities or school districts issue bonds to raise money. Without a high demand for tax-exempt bonds, municipal bond issuers would be forced to pay more to borrow or simply scrap their projects, which would, of course, be bad news for communities that need sewers, roads, schools, hospitals and so on.

Do you think there may be a change coming to the municipal bond market? I'm a little dubious that this bill has much of a chance in the House of Representatives.

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