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Subject:  Re: Bond buying Newbie Date:  10/28/2008  9:01 AM
Author:  Lokicious Number:  25006 of 36670

hat bond dividends are tax free? Regarding Treasuries, are the dividends exempt from federal and state taxes? Munis?

Municipal bonds are exempt from both federal taxes and from taxes in the state they are issued from. (This is why you see state specific muni bond funds for states with high state income taxes, such as California.)

Treasuries and TIPS are exempt from state taxes, but you pay federal taxes. (This means when you compare yields between Treasuries/TIPS and corporates/CDs,you need to factor in state taxes.)

Of course, in tax-deferred accounts, as with stocks, you will pay taxes at your marginal rate at the time of withdrawal, so tax exemptions for munis and Treasuries are irrelevant.

Usually (right now everything is very weird), you can find government insured CDs with enough higher yields than Treasuries of the same maturity to make up the difference of state taxes, even if you live in a high tax state. The disadvantage is you need to shop around, since the same bank/credit union doesn't always have the highest CD yield. Brokerages, such as Vanguard, offer FDIC brokered CDs, usually with competitive yields (close to high end), but at least Vanguard has $10,000 minimums on brokered CDs (banks and credit unions vary with minimums, but some are as low as $500). Also, most brokered CDs, like bonds, pay out the dividends semi-annually, so you then have to do something with the money—less of an issue when you start living off you income after retirement than when you are still accumulating. Many of us have opened accounts at the Pentagon Federal Credit Union, because it has pretty regularly had competitive rates, sometimes what we call "fire sales."

If you buy Treasuries or TIPS through Treasury direct, you can get them in $1000 increments for no commission at auctions. TIPS may end up paying less than CDs, but there's the x-factor of inflation (CPI-U adjustment) so you don't know in advance, as you do with Treasuries. So, we use historical numbers as the best guide we have (fixed yield above inflation). Right now TIPS look much better than Treasuries based on history, although the professional traders are assuming deflation, which will probably be correct for the next year or two.

Typically, muni bonds have been a better choice for people in the top two federal tax brackets, maybe top three if you are in a high tax state and get state specific munis. Munis have historically been at less of a default risk than corporate bonds with the same rating. Again, right now everything is out of whack and both munis and corporates have yields well above normal compared to Treasuries, because of default fears. Either there are some excellent bargains out there or the fears are real and there will be many defaults even of high rated bonds.

The starting point for any decisions is to weigh your return needs versus risks. I figure how much of a return above inflation I will need after retirement to stay solvent until age 100 (with a healthy room for error—I assume zero for social security, although it theoretically ought to provide something like 50% of expenses). Bottom line is that if you save enough, you can get away with more conservative choices.
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