Personal Finance December 8, 2009, 10:47PM EST

Investing: Tools for Tempering Taxes

Experts tell Bloomberg BusinessWeek which investing vehicles can lessen the taxman's take during tough economic times

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Just as cash-strapped consumers are more inclined to clip food coupons than they were when the economy was on firmer footing, investors need to be conscious of ways to legally minimize what they pay the government in taxes on gains in their portfolios.

"A lot of what makes an investment category tax-advantaged is based on the holding period of the asset," says Blair Anderson, a managing director at HighTower, an investment advisory firm based in Traverse City, Mich. "If you buy a position and sell it within a year, you're taxed at a higher rate"—a capital-gains levy of up to 35% instead of 15%.

"It might be good for investors to identify which assets they're willing to hold for a longer period in [building] their portfolio for 2010," he says.

Municipal bonds are of course the best-known example of tax-advantaged assets, and carry the best advantage of all—interest received on them is tax-free. But you need to be wary of bonds used to fund any nonessential services such as tobacco, sports stadiums, and airline terminals, since those are often subject to the Alternative Minimum Tax (AMT), says Anderson.

High-Yield Muni Bonds

He thinks muni bonds are a good bet for the next couple of years, as long as capital-gains and ordinary income tax rates remain at current levels. Given the expanded federal deficit, he believes it's inevitable that the government will raise income taxes, probably some time in 2011, and President Obama has talked about returning capital-gains taxes to the higher rates of the Clinton years. Anderson likes munis because they tend to provide a larger after-tax return than Treasury bonds based on higher yields. Keep in mind that munis don't enjoy the risk-free status of Treasury bonds, though they carry less risk than most other asset classes.

For people seeking more income, Anderson recommends high-yield muni bonds, which he says should only be purchased through a money manager. He uses the American Century High Yield Muni Fund (AYMAX), citing the quality of its credit research department and portfolio manager Steven Permut's nearly 12-year track record, with no defaults in the portfolio. The fund is up 23.4% year-to-date as of Dec. 7.

The success of high-yield muni funds depends on the ability of the manager's credit research department to go into the books of a municipality to understand the true value of the bonds, as well as any risk. Fund research is particularly important since the reason the bonds are paying premium yields in the first place is either the issuer is a smaller, lesser-known entity that doesn't get coverage from fixed-income analysts, or the bonds are unrated or uninsured because the issuer didn't want to pay for those services.

Anderson likes fund managers who care more about preserving capital than risking wild fluctuations in asset values in the pursuit of higher returns. He prefers that the fund buy munis used to build sewers or to support a critical electric utility or the primary hospital in the municipality instead of higher-yielding ones to build a stadium, whose risk is tied to whether the local football team stays or moves away.

Closed-End Funds

Normally at yearend, investors would be able to pick up munis at a nice discount since closed-end muni fund investors will sell assets that have had losses regardless of their underlying value in order to offset gains in other parts of their portfolios.

This year, however, the average discount is just 5% to 7%, compared with 25% a year ago. That's mostly because demand has increased on the much higher dividend payouts muni funds have been able to make this year due to ultralow borrowing costs, which have widened their yield spreads, says Cecilia Gondor, an analyst at Thomas J. Herzfeld Advisors and editor of the firm's monthly newsletter.