You can't think of one more way to shrink your 1990 taxable income and are ready to mail your returns to the IRS and Annapolis. But what about 1991? Is there anything you can do -- now -- to have more of this year's income left after taxes?
You may wish to consider a Maryland municipal bond fund to supplement or replace investments earning taxable income. Such a fund, invested only in Maryland state and local government bonds, would provide you with income that's exempt from federal, state and county income taxes. (Any capital gains also would be exempt at state and county levels.)
As appealing as the notion of investing in a triple-tax-exempt bond fund may be, such a fund isn't for everyone. One might be for you if:
1. You are able and willing to tolerate the risks involved in investing in any sort of bond fund, taxable or tax-exempt.
2. You could earn more by investing in a municipal bond fund than if you invested in a taxable bond fund and paid the federal, state and county income taxes on the dividends.
A bond fund involves two types of risk. There is market risk: Bond prices will fall if interest rates rise. And there is credit risk: Issuers of bonds may fail to pay interest or repay principal on time.
A single-state municipal bond fund, such as one invested only in Maryland issues, can raise credit risk by being concentrated in the securities of governmental units that are dependent on the economy of one state, instead of on the more diversified national economy.
If you believe that a bond fund would be suitable for part of your portfolio and that the financial conditions of Maryland's governments are strong enough to be a good risk for your money, you need to affirm that a Maryland fund would be sufficiently rewarding.
Don't assume that an investment is more attractive just because it throws off tax-exempt income. This may be the case if you are in the 28 percent or 31 percent federal tax bracket. But since the spreads between yields on taxable and tax-exempt securities expand and contract, you really need to check whether one might be right for you.
A simple way to do this is to see what a taxable investment would have to yield in order to produce more after-tax income than a tax-exempt investment would give you. You get that figure, called a taxable equivalent yield, as follows:
Let's suppose you are in the 28 percent federal tax bracket anyou pay Maryland state and county taxes at the maximum rates of 5 percent and 2.5 percent, respectively. Although they add up to 35.5 percent of your taxable income, your effective total tax rate actually is 33.4 percent because state and county income taxes are deductible on your federal return.
Now suppose you find a Maryland municipal bond fund yielding 6 percent. You subtract 33.4 percent from 100 percent and come up with 66.6 percent. Next you divide 6 percent by 66.6 percent (or .666). The result: 9.01 percent -- the yield that a taxable investment would have to produce so that you could be as well off.
Choosing a Maryland bond fund is a lot easier than finding a fund in many other categories because there are so few to study. The table shows the most recent performance data for the seven that have been in business for at least a year. Of these, three have track records of more than five; the oldest, Massachusetts Financial Services' MFS Maryland Series, began in November 1984.
Whether looking at one- or five-year data, you'll find significant differences among the funds' results, as calculated by Lipper Analytical Services. Operating expenses account for an important part of the range between leaders and laggards.
The (Dreyfus) Premier State and Franklin funds lead the list in part because their managements have been temporarily absorbing portions of their total operating expenses to boost yields. Having trimmed the rate of absorption, they're now passing along about 0.50 percent of average net assets to shareholders. The Prudential fund's Class B shares lag in part because the fund imposes an annual distribution fee of 0.50 percent, lifting its total operating expenses to 1.40 percent. Among the others, Price's fund has the lowest expenses at 0.68 percent, due partly to the large asset base ($300 million) across which it can spread costs.
Differences in portfolio strategies and tactics, of course, matter also. While all invest in investment-grade bonds, some may go for a greater share of triple-A issues and accept lower yields. Although all are invested in long bonds -- generally around 20 years -- some opt for longer maturities to enhance yields.
While an inflation scare could cause interest rates to rise, fund managers are encouraged by the prospects for Maryland municipal bonds. With $2.5 billion or so of bonds being sold annually, the new supply is hardly excessive in comparison with the potential demand.