Municipal bonds may help supplement IRA distributions

Q My accountant suggested that I invest in municipal bonds due to my high tax bracket. In the past, I have only invested in stocks and mutual funds. What do I need to know?

There are primarily two different types of municipal bonds. General obligation bonds, also known as G.O. bonds, are secured by the full faith and credit of the issuer. Revenue bonds, on the other hand, are issued by agencies such as a port authority, highway commission, or water and sewer district to build specific public works projects. Revenue bonds are backed by the revenues, or expected revenues, generated by these projects for payment of principal as well as interest.

If a municipal bond is held until maturity, the issuer is then obligated and required to repay the full face amount of the bond. If the bond is insured and is in default, the insurer then would be responsible for the repayment of the face amount. If the bond is sold prior to maturity, the investor would receive the current market value of the bond, which may be more or less than the original investment.

Bond prices tend to move inversely with interest rates.

The best candidates for municipal bond investments are high-tax-bracket taxpayers seeking a source of tax-advantaged income, often to generate income during their retirement years. Municipal bond income can serve as a nice supplement to taxable individual retirement account distributions or pension payouts, which are generally taxed at ordinary income tax rates.

Municipal bonds can be purchased directly though a securities brokerage account, either through a stock/bond broker or on your own via a brokerage's web site. They also can be purchased as a mutual fund. The main advantage of a mutual fund is the added level of diversification, as well as management expertise. Unfortunately, since most municipal bond mutual funds are open ended, there is never any point in the future where the entire portfolio matures and then pays back principal. As with all open-end mutual funds, shares can be bought or sold at any time, but at the then-current value, which may be more or less than your original investment.

If this is a concern, but you still want to take advantage of a diversified portfolio of municipal bonds selected by a professional, then a unit investment trust (UIT) may be the answer. With this vehicle, once the bonds are professionally researched and selected, the portfolio remains fixed throughout the life of the bonds. Unlike a mutual fund, which replaces bonds on an ongoing basis, the principal of each matured bond is paid out to the unit trust investors. The UIT can provide some peace of mind to those who prefer a finite life to their municipal bond portfolio, as well as the ability to essentially lock in an interest rate for the entire period.

Keep in mind that while the interest generated is federally tax-free, higher after-tax yields may actually be available in taxable bond investments. In addition, municipal bond income may make you subject to the alternative minimum tax. Be sure to consult with your tax adviser to determine if municipal bonds are appropriate for your specific situation.