Tuesday, August 13, 2013

How to Receive Dividends that are Tax Free

It sure would be nice when tax time comes around to realize that much of the dividend income you are receiving is non-taxable. So what kind of tax free dividends are these? First, many master limited partnerships, commonly known as MLPs, pay out dividends that are a return of capital, and are therefore non-taxable. However, these dividends are not really tax free as the tax has to be paid eventually when the investment is sold. MLPs are normally issued by oil and gas companies that are able to shelter the income using depreciation and amortization, which are non-out-of-pocket tax deductions.

However if you are looking for tax free income that is totally tax free, you should consider the municipal bond closed end funds, sometimes referred to as tax-free stocks or tax-free CEFs. These CEFs own municipal bonds that pay interest that is exempt from Federal income taxes and may be exempt from state income taxes if issued in the state you live in or issued by one of the US territories, such as Puerto Rico, the Virgin Islands, or Guam. Munis are generally issued by states, counties, cities, and other governmental entities such as school districts, sewer districts, bridges, and water and power departments. WallStreetNewsNetwork.com just recently updated its list of over 125 tax-free income CEFs, and more than 100 sporting yields greater than 5%.

There are many advantages besides the tax free income feature to these CEFs. Almost all of them pay dividends monthly, whereas, if you by an individual bond, the interest is paid semi-annually. CEFs have no minimum investment, whereas municipal bonds are sold in $5,000 denominations and many brokers have minimum purchase requirements of $15,000 to $25,000. You also have better liquidity with CEFs as prices are quoted real time and quotes are immediately available on the Internet. In addition, CEFs provide diversification through a group of bonds in the portfolio.

One of the funds that has been around for a while is the Dreyfus Strategic Municipal Bond Fund Inc. (DSM), which was founded in 1989. It currently yields 7.5%, and is selling for a 6.4% discount to Net Asset Value (NAV=the intrinsic value of the shares if the entire fund were liquidated). The fund does use some leverage amounting to 34%, which is far lower than many other tax free CEFs. The management fee is a reasonable 0.50%.

For New Yorkers, there is the PIMCO New York Municipal Income Fund (PNF), founded in 2001. The fund yields 7.1%, and trades at a 6.3% discount to NAV. Leverage is 42%, and the management fee is 0.65%. This CEF has the added bonus of seeking to be free of the Alternative Minimum Tax, also known as AMT, for New York residents.

California residents might want to consider the Invesco Van Kampen California Value Municipal Income Fund (VCV), yielding 7.4%. Discount to NAV is 10.5%, with 35% leverage. The company, founded in 1992, charges a management fee of 0.55%. About 5.4% is subject to AMT.

Here are some issues to watch out for before investing in tax free CEFs:
* high leverage
* high management fees
* trading at a premium to NAV
* bonds in the portfolio that may be subject to the Alternative Minimum Tax
* quality of bonds in the portfolio

The biggest risk of investing in these funds is a rise in interest rates, which will cause the bonds to fall in price and therefore the CEFs to drop in value.

For a list of tax free income closed end funds, which includes yields, discounts and premiums, leverage, management fees, date founded, and other information, go to WallStreetNewsNetwork.com.

Disclosure: Author did not own any of the above at the time the article was written.

By Stockerblog.com


bsorge said...

The title says Tax free stocks and not municipal bonds. This is misleading. Further the payments are not dividends, but this is a mute point since they are tax free provided they contain no AMT issues.

Stockerblog said...

The title says: "How to Receive Dividends that are Tax Free" which is correct.
Yes, technically, these are closed end funds and not stocks, but what I said was "sometimes referred to as tax-free stocks."
In addition, even though these are closed end funds, the distributions are referred to as dividends. For example, the Dreyfus Strategic Municipal Bond Fund says right in their annual report: "Over
the same period, the fund provided aggregate income dividends of $0.57 per common share."