Saving in a low-yield world
savings
Tax-favored bonds get second look

"A regular investor can take part (in) a muni fund," says Timothy Atkinson, a Certified Financial Planner and president and portfolio manager of Excomp Asset Management in Garden City, N.Y. "Depending on the company offering the fund, the minimum required balance could be as little as $100."

To protect his clients from having to pay out-of-state taxes, Atkinson makes sure clients only participate in municipal funds issued by their state -- that way, the interest income is also exempt from state and local taxes.

Government bonds

Unlike municipal bonds, which are often almost completely tax-exempt, bonds issued by the federal government bonds are free from state and local taxes but not federal taxes.

"The only tax-exempt bonds are the municipal bonds," Dimitroff says. "Other Treasury products like I bonds, EE Series bonds and TIPS are tax-favored."

Government bonds that offer some tax protection include:

  • Series EE savings bonds. These bonds are issued at a deep discount from face value (par) and pay no annual interest because the interest accumulates within the bond and is paid at maturity. The interest on these savings bonds is subject to federal taxes but can be deferred until maturity or redemption. However, if the interest is used to fund a qualified educational expense, it is tax-free.

  • Series I savings bonds. More commonly known as "I bonds," these pay a combination of a fixed interest rate (set when the investor buys the bond) and a semiannual variable interest rate tied to the inflation rate. Earnings on these bonds are exempt from state and local taxes. Similar to EE bonds, I bonds are exempt from taxes if used to pay qualified education expenses.

  • Treasury bills. More commonly known as "T-bills," these are short-term securities that mature in one year or less. You buy them for less than par value. When the bill matures, you receive par value. For example, you might buy a $1,000 26-week T-bill for $985. If you hold it until maturity, you'll be paid $1,000. That extra $15 is the interest you earned.

  • Treasury notes. More commonly known as "T-notes," these are issued in terms of two, three, five, seven and 10 years and pay interest every six months until they mature. The price of a note may be greater than, less than or equal to the face value of the note, depending on demand. If demand by investors is high, the notes will trade at a premium, which effectively reduces investor return. Upon maturity, investors are paid face value.

  • Treasury inflation-protected securities. More commonly known as TIPS, these bonds protect investors against inflation because the principal is adjusted every six months to keep pace with higher prices as determined by the Consumer Price Index. Thus, when the inflation rate increases, the principal amount also increases.

Government bond funds

Government bond funds only invest in debt securities issued by the U.S. government. The funds are made up of Treasury bills, notes, bonds and mortgage-backed securities issued by government agencies.

The securities within the fund are backed by the full faith and credit of the U.S. government. Taxes for government funds follow the same rules as the individual bonds held within these funds.

The funds specialize in varying maturity terms of five years or less (short-term funds), five to 10 years (intermediate-term funds) or 10 to 30 years (long-term funds).

Values of these funds fluctuate based on changing interest rates. If rates go up, the bond fund value decreases. If rates go down, the fund increases in value.

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