Now is the season for investors to prepare their taxes, or at least get their documents and receipts together for their accountant. Income investors may look at their 1099s for the dividends and interest they have received, thinking it would be great to not have to pay tax on that income.
There are a few ways to receive tax free income. 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%.
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 7.2%, and is
selling for a 6.4% discount to Net Asset Value. The NAV is the intrinsic value
of the shares if the entire fund were liquidated. The fund does use
some leverage amounting to 32%, 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 6.3%, and trades at NAV. Leverage is 39%, 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 6.7%. Discount to NAV is 7.6%, with 35% leverage. The company,
founded in 1992, charges a management fee of 0.55%.
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
Disclosure: Author did not own any of the above at the time the article was written.