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  1. Default A Tax-Free Way To Get Higher Yields

    It's been nearly eight years since the financial crisis, yet interest rates remain at recession-like levels. That's good news for economic growth -- but it's a dismal situation for conservative investors relying on income, including millions of retirees who don't want to take big risks to achieve a decent yield.

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    The traditional safe havens -- savings accounts, money market funds, CDs -- offer yields that are laughably low. Money market mutual funds investing in government paper currently yield only around 0.33%. Your bank may offer 0.6% on a money market account, which invests in corporate debt but is FDIC-insured up to $250,000. Five-year CDs pay 1.2%, which is a paltry annual return for the privilege of locking up your money for half a decade. And recall that these rates were even lower before the Fed raised short-term rates by 25 basis points (0.25 percentage points) in December.

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    Now, it's true that part of the reason that yields are low is that inflation has been close to nonexistent for years; some important goods and services -- such as gasoline, natural gas and flat-screen TVs -- have declined in price. So low yields haven't been devastating in terms of purchasing power. But for folks living off their savings who want to preserve principal over the long term, the prospect of low yields over the long term is troubling.

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    The good news is that there's a higher-yielding alternative to "cash" investments like savings accounts and money market funds that carries only slightly more risk: municipal bonds. Muni bonds -- and the funds that invest in them -- also have the advantage of being partly or fully tax-free: you don't have to pay federal income taxes on the income, and if you buy bonds or funds that invest solely in your own state's municipal bonds, you can forego state and local taxes, too. (Check with your accountant to make sure.)

    Because of the tax advantage, municipal bond funds are especially attractive for investors in the highest tax bracket (for 2016, single filers making $415,051 or more, or joint filers making $466,951 or more); the taxable-equivalent yield declines for taxpayers in lower brackets.

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    While it's possible to invest in individual municipal bonds, it's smart to use mutual funds for your muni investments. A well-run diversified fund invests in a wide range of bonds (T. Rowe Price Tax-Free Income Fund (MUTF: PRTAX), for example, currently owns 442 bonds) -- which minimizes the damage should a bond be downgraded or an issuer defaults (a rare occurrence with investment-grade muni bonds in any case). Professional management also allows for identification of undervalued bonds and continual reinvestment into higher-yielding bonds if interest rates rise.

 

 

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