Getting a Great Tax Return Prepared for Less than $100

Steve for Evergreen Small Business writes: I had a couple of people challenge me this tax season on our pricing.  One guy called on the telephone asking if we’re actually serious that our minimum price equals $500. (We are.) 

Another person, after getting a quote from me of over a thousand dollars, just shook his head and said he couldn’t understand why a tax return didn’t cost something more along the lines of $150.

I’ve pondered all this off and on over the weeks since these comments. And the more I ponder, the more these two taxpayers seem right. Somebody absolutely should be able to get a great tax return prepared for a decent price. A price far less than what firms like ours charge.

After brainstorming about this quite a bit, therefore, I’ve got three tips for people who want a high quality tax return prepared for less than $100.

You can, I truly believe, get such a tax return if you follow three simple tips…

Tip #1: Simplify Your Finances

Most of the cost of preparing a tax return flows either directly or indirectly from the complexity of the taxpayer’s finances.  Accordingly, your first step to reduce tax return preparation costs is simplification. You want to strip all the complicated stuff from your return.

For example, you must eliminate any foreign investments. These easily produce complexities related to foreign tax credits. And these foreign investments may (if your account balances grow) trigger requirements for massive amounts of complicated, risky disclosures. Yikes.

Similarly, you should avoid any investments that mean you need to allocate your income among multiple states. For example, don’t invest in out of state real estate. And, for goodness sake, don’t become a co-owner in an S corporation or partnership that operates across state lines.

Filing tax returns in multiple jurisdictions represents a sure way to jack the costs of return preparation. You don’t get to go international or multistate and keep your costs low. No way.

But filing a stack of tax returns isn’t the only way that people complicate their tax returns and then jack up the expense of preparation. Becoming an active investor who owns or operates sideline businesses or investments (including rental properties) jacks the complexity and costs of a return. So does trading shares of stock and mutual funds.

You also want to avoid all these complications. Seriously.

If you keep your income sources simple and straight forward enough that they can be reported on a W-2 or on a 1099 statement from a mutual fund company like Vanguard or Fidelity, you make your tax return a walk in the park. And easy means cheap.

Note: If you want to trade mutual funds or stocks and you do so inside of a retirement account, you won’t create complexity for your tax return. I am not saying, by the way, that it’s a good idea to actively invest and attempt to trade stocks. In my opinion, you ought to use a passive approach based on a handful of low-cost index funds. I’m just saying if you are going to, for example, day trade; don’t create a situation where you need to report this activity on your tax return if you’re interested in keeping your tax return preparation costs low.

Tip #2: Do Out-of-tax-season Tax Planning

Okay, so here’s another tip: I think if you’re trying to save costs that you may as well do your own tax planning. 

Good tax planning gets too expensive–especially if you’re dealing with complicated tax returns.

But if you simplify your situation, you can pretty easily do your own planning. And here’s how I’d go about that: Sometime mid-year, get one of the popular tax preparation guides and read through it.

You can skim the parts that deal with the complicated stuff you’re dropping out of. But do closely read all the other stuff. 

I bet you can do your skimming and reading in less than a couple of hours. For sure less than four hours.

The big tax planning gambits available to regular folk, for example, revolve around retirement account choices like Individual Retirement Accounts and 401(k) options and around tax credits and deductions for education and children. So really dig into these topics.

A caution: You’re not with a do-it-yourself approach trying to identify some complicated strategy that might work or some gambit that’s safe but requires a bunch of accounting. Rather, you simply want to make sure you aren’t missing some big tax savings gambit that’ll save you several hundred or several thousand dollars a year.

By the way, I have a couple of short tax planning ebooks for small business owners and real estate investors. But if you’re really trying to grind down your tax return preparation costs, you probably won’t have a business or real estate. (That makes sense, right? You’re looking for ways to keep your stuff really simple.) So I’m not thinking that super-cost-conscious people buy and read those titles.

I’m suggesting something more along the lines of the J.K. Lasser or the Ernst & Young tax guide. You can purchase these books and pay around $20 (including shipping and sales tax.)

Tip #3: Use TurboTax or TaxCut

Here’s my last tip… Don’t go to some paid preparer for a return. Do it yourself.

In other words, go out and buy a copy of a TurboTax or H&R Block Tax Cut.

For $30 to $50, you’ll be able to download good software you can use to easily do a simplified tax return. I bet the process will only take an hour or two. Even if you’re not really a computer person.

Yes, you’ll have to deal with Schedule A’s itemized deductions stuff on your own. But if you’ve kept your finances simple in all other ways, the itemized deductions stuff will be easy.

Let me point out here that if you have simplified your finances to the point where you can do your own planning using a $20-ish book like J.K. Lasser’s annual tax guide and to the point where you can do your own preparation using $40 software like TurboTax, you should easily be able to spend less than $100. Even after accounting for any other nickel-and-dime items like paper, postage and paperclips.

Furthermore, you may not have much more than half a Saturday’s work.

Evergreen Small Business

A practical how-to blog for Washington small businesses by a Seattle CPA, Stephen L Nelson, click here to visit his firm.

11 Questions to Ask When You Choose a Tax Accountant

Andy Rachleff for WealthFront writes: If you are considering early exercising of a significant number of options or are thinking about selling options in the public market for the first time we highly recommend retaining a reputable tax accountant. We realize this means you will incur a fee, but it is highly justified given the risk you take on incurring significant unforeseen taxes if you don’t consult a great tax accountant.  It is not as easy to quantify the savings from hiring a tax accountant as it is from hiring an estate planner (see our recent post by Abe Zuckerman regarding Estate Planners), but it’s just as necessary. Like most people, you’re probably not sure how to choose a tax accountant.  Here are the top 11 questions (not in priority order) we think you should ask:

• Do they have expertise in areas relevant to you?
• How many years of individual tax experience do they have?
• What license(s) do they have?
• Do they have an advanced degree?
• Will they represent you if you are audited?
• Will they review your past tax returns at no charge?
• What fees will they charge?
• Is there anything I can do to keep fees down?
• Are you comfortable with your prospective accountant?
• Who will actually work on your return?
• Does the advisor need to be local?

Do they have expertise in areas relevant to you?

If you work for a technology company that issues stock options or RSUs, then make sure your accountant has worked with plenty of other clients in the same situation.  Better yet, make sure she has clients who work in more senior positions than you because with seniority usually comes more complexity. A true professional will tell you if she is not appropriate for the job, either because your return is too simple to warrant her help or too complex due to her lack of relevant experience (a common example where a lot of experience is needed would be the area of oil and gas partnerships).

How many years of individual tax experience do they have? 
An appropriate tax advisor should have a minimum of five years experience doing individual tax returns. Experience with a large firm is usually better than a small firm because she will have been exposed to a broader set of issues and her training should be better.

What license(s) do they have?

It would be preferable for your tax preparer to have a CPA (Certified Public Accountant license) although it is not technically required. Tax Attorneys should have a LL.M in Tax (an advanced tax degree for an attorney).

Do they have an advanced degree?

A CPA can do tax work even if she hasn’t had any special training in tax. I know that sounds crazy. That’s why it might make sense to look for someone with more advanced training like a tax specialty within an MBA. My tax advisor, Bob Guenley (who has written a number of guest posts for us), told me he only took one tax course in college and learned a lot on the job, but getting his MBA in tax made a whole world of difference. His MBA included individual, partnership, corporate and fiduciary tax, which is more than one needs if she wants to specialize in individual tax, but it’s awfully nice to have someone advise you who has that broad perspective. An advanced degree isn’t necessary if your accountant has taken advanced classes in personal tax as part of her ongoing Continuing Professional Education requirement. There is no correct answer to this question. I just think your tax advisor/preparer needs to have taken several courses emphasizing personal taxes.

Will they represent you if you are audited?

A professional tax preparer should stand by her tax return and represent you in the unlikely case you are audited (for an additional fee).  It’s a real red flag if she is reluctant to engage on this issue.

Will they review your past tax returns at no charge?

An outstanding tax advisor should because it typically takes as little as 15 minutes on most people’s prior returns to determine if she would be comfortable preparing your return.  Advanced cases might take 30 minutes.  A capable professional should ask you to send your prior returns in advance of your meeting so you can spend your meeting time more productively.

What fees will they charge? 

I believe the only fair way for a tax advisor to charge is by the hour.  Your hourly fee will vary by location (i.e. San Francisco clients will pay more than Sacramento clients).  A senior advisor/partner from a large firm in the Bay Area will likely charge $600  - $700 per hour, and a senior advisor/partner from a small firm will likely charge half that much. That translates to a total bill of approximately $2,000 – $3,000 at a large firm and $1,000 – $1,500 at a small firm if you assume your advisor spends an hour with you discussing your situation prior to preparing your tax documents and an hour reviewing your return once it has been prepared and a lower cost staff member handles the data input and operates the software that calculates the return.  You should expect a higher bill if you have a lot of K-1s and/or income from more than one state (because each state requires its own return).  You might only want to spend this kind of money the first time you exercise your options to ensure you don’t run afoul of issues like the Alternative Minimum Tax (AMT) and quarterly estimated taxes.  But if you’re like most people, once you hire an accountant to prepare your taxes (and are happy with the job they did), you will likely want them to do it every year.

What can the client do to keep their fees down? 

The better organized you are, the less time your accountant will need to search for information which translates to lower fees. Don’t dump a bunch of crap on your CPA that she has to decipher.  If you own your own business, send a spreadsheet or a Quicken, Mint or QuickBooks file that contains all your income and expenses rather than all your invoices; give list of charities vs. copies of all letters/canceled checks; provide most of the data at one time and not in pieces, because the more your accountant has to pick up and put down a file, the more the clock runs.

Are you comfortable with your prospective accountant?

The odds are you are going to face a number of difficult tax-related decisions over time, so you need to feel comfortable asking your accountant what you may feel is a stupid question. When it comes to taxes there are no stupid questions, because the tax code is not always logical. Make sure you select someone you can ask anything and with whom you are willing to share everything.

Who will actually work on your returns?

If you talk to someone who works in a large firm then you need to determine who will actually work on your taxes and who will be your point of contact.  As we explained in the previous point, you need to be comfortable with the person actually providing the advice, so make sure you’re not going to be shunted over to a more junior person when you need to talk to someone. You also don’t want to have to pay for time spent with an “account manager” who always has to go to the expert for the answer.

Does your advisor need to be local?

This is really a question for you and not your potential tax advisor.  It is not necessary for your accountant to be local given the ease with which you can send documents via email and Dropbox.  It really comes down too whether you need to actually see your accountant to get comfortable with her advice.

Obviously the right answer to most of these questions depends on your individual situation and needs.  Hopefully these 11 questions will help you select the right advisor when the time comes.

 Wealthfront is the world's largest & fastest-growing automated investment service with over $800 million in client assets. We manage a diversified, continually rebalanced portfolio of index funds on your behalf at a very low cost and in an extremely tax efficient manner. Our unique service is made possible by combining a team of world-class financial experts, led by Dr. Burton Malkiel, renowned economist and author of A Random Walk Down Wall Street, with some of Silicon Valley’s best technology talent.

You can visit Wealthfront here.

Avoiding The 10% 401(K) Tax Penalty

Aaron Weems for Fox Rothschild LLP writes: As the nation emerges from the fog of tax season, many people who paid little attention to their taxes for the previous eleven months just received a crash course in tax planning, either on their own or with their tax professional. If they have a 401(k), they dealt with their retirement account in some way, either by having to pay tax on a distribution or looking at what they were able to contribute over the year; perhaps they were making one last payment before the tax filing deadline.

For many people, however, having a 401(k) plan begins and ends with a few simple actions: sign up for a plan through your job; contribute a pre-tax amount from each paycheck, and; never deal with it until you retire.

Such a simplified approach is a great way to ensure consistent savings and a retirement nest egg. It is not, however, the end of the equation. Recently, Paul T. Murray, president of PTM Wealth Management, wrote a blog entry on five techniques for avoiding the 10% tax penalty for an early withdrawal from a 401(k). This is great information because it sheds light on a practical issue many people going through a divorce or separation face: having to use the only accessible financial account available to them – the 401(k) – before they reach the mandatory distribution age.

Paul highlights five areas where people can avoid paying the 10% tax penalty on an early withdrawal. Not surprisingly, they are complicated and require significant planning to successfully utilize. The most intriguing, in my opinion, is the one-time withdrawal from a rollover of 401(k) funds. Many times a dependent spouse either had no retirement account or a lightly funded account. When the time comes for them to receive a substantial rollover from their spouse's 401(k) to their IRA, the IRS provides for a one-time withdrawal in any amount. This could be a major tool for a spouse who is in a case with little cash in the marital estate and has the immediate need for cash. It might be the cash infusion they need to pay off a debt or cover their expenses as they transition into their new phase of life.

Four other techniques are highlighted and the blog entry is worth reading. The tax code is complicated, but if you know where to look it can also provide for some creative solutions to financial and tax problems.

Ten Things to Know about IRS Notices and Letters

Each year, the IRS sends millions of notices and letters to taxpayers for a variety of reasons. Here are ten things to know in case one shows up in your mailbox. 

1. Don’t panic. You often only need to respond to take care of a notice.

2. There are many reasons why the IRS may send a letter or notice. It typically is about a specific issue on your federal tax return or tax account. A notice may tell you about changes to your account or ask you for more information. It could also tell you that you must make a payment.

3. Each notice has specific instructions about what you need to do.

4. You may get a notice that states the IRS has made a change or correction to your tax return. If you do, review the information and compare it with your original return.

5. If you agree with the notice, you usually don’t need to reply unless it gives you other instructions or you need to make a payment.

6. If you do not agree with the notice, it’s important for you to respond. You should write a letter to explain why you disagree. Include any information and documents you want the IRS to consider. Mail your reply with the bottom tear-off portion of the notice. Send it to the address shown in the upper left-hand corner of the notice. Allow at least 30 days for a response.

7. You shouldn’t have to call or visit an IRS office for most notices. If you do have questions, call the phone number in the upper right-hand corner of the notice. Have a copy of your tax return and the notice with you when you call. This will help the IRS answer your questions.

8. Keep copies of any notices you receive with your other tax records.

9. The IRS sends letters and notices by mail. We do not contact people by email or social media to ask for personal or financial information.

10. For more on this topic visit IRS.gov. Click on the link ‘Responding to a Notice’ at the bottom left of the home page. Also, see Publication 594, The IRS Collection Process. You can get it on IRS.gov or by calling 800-TAX-FORM (800-829-3676).

Additional IRS Resources:

• Tax Topic 651 - Notices – What to Do
• Tax Topic 652 - Notice of Underreported Income – CP-2000
• Tax Topic 653 - IRS Notices and Bills, Penalties and Interest Charges

3 Reasons Bookkeepers Think QuickBooks Online Sucks

We read everything.....and Joe Mazur for Salt Lake City Bookkeeping writes:  3 Reasons Bookkeepers Think QuickBooks Online Sucks  /  Great bookkeeping is all about working efficiently, accurately, and swiftly.  A majority of this depends on the ease of access to transactions and the software provided.  QuickBooks is the prefer software for a majority of small businesses, but not all of the QuickBooks' products are the same.  Take QuickBooks Online for instance.  Is provides great benefits such as online access and multiple device interfacing but it doesn't provide great bookkeeping functionality.  As bookkeepers, most of our group discussions about crappy software tend to gravitate towards QB Online. Here are a few of the topics that seem to pop up again and again.  

Financial And General Reporting

Nothing is better than showing a client a handful of financials reports and discussing the ebb and flow of the numbers between them.  Nothing is worse than having to hit the back or forward buttons in Chrome or FireFox over and over again to get to and from those reports during a monthly review.  As virtual bookkeepers, time equals money.  If you are constantly toggling between reports every second counts.  Any dialed bookkeeper knows that jumping between Cash and Accrual reporting while analyzing Profit & Loss Reports, Balance Sheet Summaries, Accounts Receivable Aging, etc. is a task that needs to be performed quickly.  Why make that task more painful by watching a cursor timer 'think'.

Keyboard Shortcuts

Having multiple reports open is great if you can quickly navigate through them.  Not being able to use shortcuts to jump back and forth really slows down the 'review' portion of great monthly bookkeeping support.  QuickBooks Online has limited shortcuts and this could take a 10 second tasks up to 30 seconds.  Who wants to spend 3 times longer doing anything?  No one really enjoys using the calculator on their phone since QB Online doesn't have one.  Another great feature of QuickBooks desktop products is being able to calculate directly in the field.  This awesome feature doesn't exist in QB Online.  Again, shortcuts equal time and time always equals money.

The Price

I understand that some small business owners are strapped for cash and forking over $200 sounds like a lot of money initially.  So they settle for $38 per month or something close to that for QB Online.  After a few years, that could add up to almost $1,000 for QB Online while some of the other Intuit products are around $200.  Is the access alone worth $800? Probably not.  Why not opt for the cheaper route and utilize LogMeIn or a remote desktop solution instead.  This also speeds up the bookkeeping process so time is saved and therefore money is saved.   The extra money can be used for hiring another employee, buying better computers, a company car, etc.   Use that extra time to do something valuable.  This could mean several different things such as; focusing on sales, grow revenues,  work on your inbound marketing campaign, take working vacations in Cape Cod, float rivers in Idaho, Bike in Fruita, ski pow, etc.

The main take away from this is that QuickBooks Online does provide some benefits, just not from a bookkeeper's standpoint.  Have a solution that is a great substitute? Please reach out and tell me more.  Do you want to hear about what we've come up with?  Reach out and I can tell you our ideas.  Bookkeeping should be fun, not frustrating or time consuming.

Turbo Tax Accuracy Guarantee Experience

Over at Bogelheads we came across the following discussion: Turbo Tax Accuracy Guarantee Experience

Turbo Tax Accuracy Guarantee Experience

by EagertoLearnMore » Mon Apr 21, 2014 9:16 am

Does anyone have experience using the Turbo Tax Accuracy Guarantee? I just received a letter from my state department of revenue indicating that there was an error in the amount paid for state income tax. I pulled out my TT forms and the correct amount was entered, but on another state form that carried over the dollars, the amount was in error. There is a form within TT that indicates what I entered and that is correct so it was not a clerical error. However, in calculating the state income tax TT picked up an incorrect number and used that.

I have contacted TT and received an incident number. In order to use the guarantee I believe I have to provide access to my tax returns. I do not feel comfortable with that so I am asking if anybody has any experience with this type of problem. I have used TT for years, but I just lost confidence in the software since this is a very simple thing that is incorrect.

EagertoLearnMore

Posts: 346

Joined: 30 Jun 2010

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Re: Turbo Tax Accuracy Guarantee Experience

by scouter » Mon Apr 21, 2014 10:57 am

I don't have direct experience with an accuracy claim, but I can tell you that last year I filed electronically and found out later that one of the schedules was not received by the IRS. Of course, this resulted in a letter from the IRS asking for additional payment, (with the usual threat of penalties, interest, and placing a lien on our house.) I went back to the TT file, printed it out and sent it to the IRS, and they accepted it with no additional payment owed.

I filed this years return on paper so that I could ensure everything necessary was included.

scouter

Posts: 569

Joined: 29 May 2010

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Re: Turbo Tax Accuracy Guarantee Experience

by jimb_fromATL » Mon Apr 21, 2014 11:18 am

I don't see how their accuracy guarantee will help much. According to their guarantee, they would pay any penalty and interest up until the first notice -- not the difference in tax-- if the error was because of their software, after you've filed an amended return. But chances are there won't be a penalty or interest if you file an amended return and can prove to the state that it was a problem with the software.

TurboTax FAQs

jimb

jimb_fromATL

Posts: 330

Joined: 10 Nov 2013

Location: Atlanta area & Piedmont Triad NC and I-85 in between.

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Re: Turbo Tax Accuracy Guarantee Experience

by Ace1 » Mon Apr 21, 2014 1:03 pm

Would you divulge which state ?

Ace1

Posts: 51

Joined: 26 Dec 2010

Location: Twinsburg Ohio

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Re: Turbo Tax Accuracy Guarantee Experience

by harmony » Mon Apr 21, 2014 9:53 pm

What you describe or something very similar happened to us a few years ago. We found the error before filing because we always do a paper version to verify what TT is doing. When we found the error it was still early enough that we could get the money back that we had spent on TT software. (Their money-back satisfaction guarantee is currently 60 days--don't recall how long it was back then.) We made a phone call to TT's customer care department, explained the error that occurred, and they refunded us the full purchase cost of the desktop version. There were no further questions asked. We did not need to submit any of our tax documents. Since we had not filed at that point, this saved them the cost of penalty and interest they would have had to pay if the error had been filed.

Taxation Of Copyright Sales: Ordinary Income Or Capital Gain?

David A. Kluft for Foley Hoag LLP writes: Tax day presents several interesting questions for copyright holders, not the least of which is how the Internal Revenue Service (IRS) will treat income from the sale or exclusive license of a copyright. If a copyright is a "capital asset," proceeds from its sale or exclusive license are a capital gain rather than ordinary income, and the transaction will be taxed at a much lower rate.

Prior to 1950, whether a copyright was a capital asset was largely determined by the professional status of the author. A copyright was not a "capital asset" if could be described as "inventory" of that profession, or "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business." So, for example, in Fields v. Commissioner, the Second Circuit held that, where the taxpayer was a professional playwright, sale of the film rights to a play was a transaction "in the ordinary course" of this profession, and thus should be treated as ordinary income.

But there was confusion around the edges. For example, in Estate of Chandor v. Commissioner, painter Douglas Chandorhad volunteered to create a portrait of Franklin Roosevelt, Joseph Stalin and Winston Churchill at the Yalta Conference, but Stalin scuttled the plan by refusing to sit. This left Chandor with a draft "study" of Churchill, which he sold in 1948 to financier Bernard Baruch for $25,000. The IRS argued that, because Chandor was a professional painter, the proceeds from the sale of any of his paintings should be treated as ordinary income. But the United States Tax Court disagreed. Although Chandor was a professional portrait painter, he had previously painted only specifically commissioned works, and had never before created a painting and then held it for sale. Moreover, the painting was only a study, and "usually these studies are never disposed of until after the death of the artist." Therefore, it was improper to treat the painting as if it were ordinary "inventory" held for sale to customers, and the income from its sale was a capital gain.

In 1950, Congress sought to diminish uncertainty in this area of the law by passing what is now codified at Section 1221(a)(3) of the Internal Revenue Code. That section provides that "capital assets do not include ... a copyright ... held by ... a taxpayer whose personal efforts created such property." In other words, individual artists like Chandor could no longer treat as a capital gain the income from the sale of the rights in their own work, regardless of the context. So, for example, inStern v. United States, a Louisiana federal court held that, "unfortunately for the taxpayer," the sale of the "Francis the Talking Mule" franchise by its author, shortly after this new law went into effect, had to be treated as "ordinary income." In 2005, Congress amended Section 1221 to allow copyrights in musical works to be treated as capital assets, but other types of creative work are still subject to Section 1221(a)(3).

Notably, the IRS has indicated that the reference in Section 1221(a)(3) to "personal efforts" may limit its application to individuals, thus excluding corporations. However, in Revenue Ruling 1962-141, the IRS ruled that the sale of television broadcast rights by corporations, because it had become a common practice in the entertainment industry by that time (1962), should be treated as if it were inventory sold "in the ordinary course" of that business, and thus any profit from the sale of such rights was ordinary income. As a practical matter, this suggests that, even if a copyright holder is a corporation or an individual not subject to the "personal efforts" language, the IRS is still likely to view proceeds from the transfer of these properties as ordinary income, provided that such transfers regularly occur within the relevant industry. Businesses and individuals with questions about the appropriate tax treatment of copyright transfers should consult a specialist.

To view Foley Hoag's Trademark and Copyright Law Blog please click here

Constructing A High-Income, Tax-Exempt Portfolio With CEFs

John Dowdee for Seeking Alpha writes: Constructing A High-Income, Tax-Exempt Portfolio With CEFs

Summary

• A portfolio of municipal bond CEFs is a compelling way to receive high tax-exempt income.
• Municipal bond CEFs have provided excellent risk-adjusted returns over the long term, but faltered last year.
• Municipal bond CEFs have outperformed similar ETFs on a risk-adjusted basis during the past 5 and 3 years periods.

As a retiree I am always looking for high income opportunities. Most of my portfolio is held in an IRA account so I do not have extensive experience with municipal bonds. However, I understand that many retirees have taxable account and I have received several requests to analyze the risk versus rewards of this asset class. This article reviews several popular municipal bond Closed-end funds (CEFs) to determine their relative performance in terms of risk-adjusted return.

Municipal bonds are issued by local governments and associated agencies including state, cities, counties, public utilities, school districts and redevelopment entities. The bonds may be general obligations (not tied to a particular income stream) or bonds secured by specific revenues. Typically municipal bonds are exempt from Federal Income tax and some may also be exempt from state taxes. This makes this asset class attractive to investors in higher tax brackets.

It should be noted that if municipal bonds are sold to finance "private activities" such as airports and some housing agencies, these bonds may be subject to the Alternative Minimum Tax (AMT). AMT is a special way to compute taxes by eliminating some deductions and credits. The bonds associated with AMT typically pay higher yields to compensate the buyer for the potential taxable risk.

Historically, municipal bonds have a low rate of default but municipalities have been in a difficult position since the 2008 financial crisis. Some of the rating agencies issued "negative outlooks" on some municipalities in 2013, which, coupled with the potential for higher interest rates, resulted in a sell-off of muni-related assets in 2013. The filing for bankruptcy by Detroit, Michigan, also has a chilling effect. Closed-end funds (CEFs) were hit even harder due to their use of leverage and price discounts generally widened. The market is expected to improve this year so now may be a good time to consider this asset class.

Another important metric when investing in bonds is an assessment of the effective duration. Duration is a term that helps you to understand the interest rate risks. Duration is different than the maturity - maturity indicates how long a bond will be in existence. For instance, if you buy a 10-year bond, the principal will be repaid at the end of 10 years and the maturity is said to be 10 years. Duration is a more complicated concept. Mathematically, duration is a complex formula that represents the weighted average of the time it takes the cash flow from the bond (including the final par value payment) to reimburse the price of the bond. If a bond pays interest at set intervals, the duration is always less than the maturity.

Most bond funds provide an estimate of the average duration of their holdings so investors do not need to know how to calculate this metric. The important thing to understand is that duration is a measure of how sensitive the fund is to interest rate changes. For each 1% rise in interest rates, a bond fund will typically decline an amount equal to the average duration (or vice versa, the fund will increase in value by the average duration if interest rates fall 1%). As an example, if a fund has a duration of 5 years and interest rates rise by 1%, then you would expect the value of the fund to decrease by 5%. If a fund uses leverage, this will increase the effective duration. The change in price may not exactly track with the duration (there may be other factors at work) but duration is a good indication of interest rate risk.

There are approximately 100 CEFs that invest in municipal bonds. To narrow down the scope of my analysis, I selected only municipal funds that were rated "bronze" or better by Morningstar. Morningstar provides a comprehensive fundamental analysis of bond funds and the "bronze" rating means that the Morningstar staff expects the fund to outperform its peer group over the next five years. In addition, I only considered funds that were national in scope and not limited to a particular state. The following nine CEFs met my criteria.

1. BlackRock Muni Intermediate Duration (MUI). This CEF sells for a discount of 9.3%, which is below the 52-week average discount of 6.5%. The portfolio consists of 251 intermediate-duration municipal bonds and related securities. The effective duration is 8.6 years, which makes this fund less sensitive to interest rates than other longer duration CEFs. About 92% of the bonds are investment grade and about 16% of the holdings are subject to the Alternative Minimum Tax. The fund utilizes 39% leverage and has an expense ratio of 1.9% including interest payments. The distribution rate is 5.8%.
2. BlackRock Municipal Income (BFK). This CEF sells for a discount of 5.9%, which is below its average discount of 2.9%. the portfolio consists of 218 municipal bonds and related securities, with an effective duration of 10.2 years. About 80% of the holdings are investment grade and 11.3% are subject to AMT. The fund utilizes 40% leverage and has an expense ratio of 1.7%, including interest payment. The distribution rate is 6.8%.
3. BlackRock Municipal Income II (BLE). This CEF sells for a discount of 4.1%, which is below its average discount of 1.3%. The portfolio consists of 211 municipal bonds and related securities with an effective duration of 10.9 years. About 80% of the holdings are investment grade and 9.6% are subject to AMT. The fund utilizes 42% leverage and has an expense ratio of 1.7% including interest payments. The distribution is 7%.
4. BlackRock MuniHoldings Investment Quality (MFL). This CEF sells for a discount of 9%, which is below its average discount of 6.6%. The portfolio consists of 162 municipal bonds and related securities, with all being investment grade and 96% being AA or higher. In addition, about a third of the holdings are covered by insurance. The effective duration of the portfolio is 9.4 years and 12.5% of the holdings are subject to AMT. The fund utilizes 43% leverage and has an expense ratio of 1.7% including interest payments. The distribution is 6.4%.
5. BlackRock MuniVest (MVF). This CEF sells for a discount of 4.2%, which is below its average discount of 1.2%. The portfolio consists of 185 municipal bonds and related securities, with 93% being investment grade (71% rated AA or higher). The effective duration is 9.0 years and 11.9% of the portfolio is subject to AMT. The fund utilizes 40% leverage and has an expense ratio of 1.5% including interest payments. The distribution is 7.1%.
6. BlackRock MuniVest II (MVT). This CEF sells for a 2.3% discount, which is below the average premium of 0.2%. The portfolio consists of 218 municipal bonds and related securities, with 86% being investment grade (70% AA or higher). The effective duration is 9.9 years and 9.2% of the portfolio is subject to AMT. The fund utilizes 41% leverage and has an expense ratio of 1.7% including interest payments. The distribution is 7.1%.
7. BlackRock MuniYield (MYD). This CEF sells for a 4.8% discount, which is below its average discount of 2.3%. The portfolio consists of 249 holdings of municipal bonds and related securities, with 85% being investment grade (55% AA or higher). The effective duration is 10.4 years and 9.6% of the portfolio is subject to AMT. The fund utilizes 40% leverage and has an expense ratio of 1.5% including interest payments. The distribution is 7%.
8. BlackRock MuniYield Quality (MQY). This CEF sells for a discount of 6.7%, which is below its average discount of 4.1%. The portfolio consists of 245 municipal bonds and related securities, with 95% being investment grade (86% AA or higher). About half the portfolio is covered by insurance. The effective duration is 9.9 years and 16.8% of the portfolio is subject to AMT. The fund utilizes 40% leverage and the expense ratio is 1.5% including interest payments. The distribution is 6.6%.
9. BlackRock MuniYield Quality II (MQT). This CEF sells for a discount of 7.4%, which is below its average discount of 6.7%. The portfolio consists of 234 municipal bonds and related securities, with 97% being investment grade (89% AA or higher). About half the portfolio is covered by insurance. The effective duration is 9.8 years and 14.2% of the portfolio is subject to AMT. The fund utilizes 40% leverage and has an expense ratio of 1.5%. The distribution is 5.7%.
10. BlackRock MuniYield Quality III (MYI). This CEF sells for a discount of 6.5%, which is below its average discount of 5.2%. The portfolio consists of 284 municipal bonds and related securities, with 96% being investment grade (92% AA or higher). The effective duration is 9.6 years and 16.9% of the portfolio is subject to AMT. About half the portfolio is covered by insurance. The fund utilizes 40% leverage and has an expense ratio of 1.4% including interest payments. The distribution is 6.5%.

To analyze risks, I used the Smartfolio 3 program (smartfolio.com). Figure 1 provides the rate of return in excess of the risk-free rate of return (called Excess Mu on the charts) plotted against the historical volatility over the past five years. I also included the following Exchange Traded Funds (ETFs) to provide a frame of reference.

1. iShares Barclay 7-10 Year Treasury ETF (IEF). This ETF tracks an index of U.S. treasury bonds that have maturities between 7 and 10 years. The effective duration is 7.6 years. The expense ratio is 0.15% and the yield is 1.8%.
2. iShares National AMT-Free Muni Bond (MUB). This ETF is one of the largest and most liquid municipal bond ETFs. It holds more than 2,000 bonds, with 97% investment grade (68% AA or higher). It has an effective duration of 6.6 years and an expense ratio of 0.25%. The yield is 3%.

(click to enlarge)

Figure 1: Risk Versus Reward Municipal CEFs Past 5 Years.

Figure 1 indicates that there has been a wide range of returns and volatilities associated with municipal bond funds. For example, MVF had a relatively high return but also had a high volatility. Was the increased return worth the increased risk? To answer this question, I calculated the Sharpe Ratio for each fund.

The Sharpe Ratio is a metric developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the figure I also plotted a red line that represents the Sharpe Ratio of IEF. If an asset is above the line it has a higher Sharpe Ratio than IEF, which means it has a higher risk-adjusted return than intermediate-term treasury bonds. Conversely, if an asset is below the line, the reward-to-risk is worse than IEF.

Some interesting observations are apparent from the plot. Over the past 5 years, municipal CEFs have had excellent performance, handily beating both IEF and MUB. The CEFs are packed into a relatively small area of the reward-to-risk plane. MVT and MUC had the best risk-adjusted performance with BLE close behind. The performance of the other CEFs lagged slightly but still generated impressive results when compared to the municipal bond ETF, MUB. These results are not too surprising. With the exception of 2013, municipal bonds were in a bull market, which favored leveraged products.

As you may have noticed, all the selected CEFs were from BlackRock. Therefore, I wanted to see if you received any diversification by investing in multiple BlackRock offerings. To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the selected funds. The results are provided in the 5-year correlation matrix shown in Figure 2. I was somewhat surprised to see that these CEFs were not very correlated. Most of the correlations were in the 40% to 60% which indicates that you do receive the benefits of diversification if you invest in multiple CEF funds.

(click to enlarge)

Figure 2. Correlation Matrix Over Past 5 Years

I then combined these 9 CEFs into an equally weighted portfolio. The portfolio has an average distribution over 6.5% tax-exempt, which satisfies by desire for high income. However, I also wanted to assess the risks. The risk versus reward of the combined portfolio is shown as a "red dot" on the figure. As you can see, the combined portfolio had a volatility that was less than the constituent volatilities. This is an illustration of an amazing discovery made by an economist named Markowitz in 1950. He found that if you combined certain types of risky assets, you could construct a portfolio that had less risk than the components. His work was so revolutionary that he was awarded the Nobel Prize. Over the past 5 years, this CEF portfolio had excellent performance and substantially outperformed both IEF and MUB on a risk-adjusted basis.

Next I wanted to assess if the outperformance continued into more recent times. I re-ran the analysis over the 3 years from April 2011 to April 2014. The results are shown in Figure 3. The relative performance was good but not quite as impressive as the 5-year period. MUC, MVT and MYI led the muni pack. MUI and MFL had risk-adjusted performance the same as IEF. Again, all the CEFs handily beat MUB on a risk-adjusted basis but it should be noted that MUB had the least volatility of all the muni funds. The equally weighted portfolio still exhibited outstanding performance over the 3 year timeframe.

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Figure 3: Risk Versus Reward Municipal CEFs Past 3 Years.

The investment landscape became even murkier in the more recent past. Since early last year, the fear of rising rates took its toll on muni bond funds. The worst of the sell-off appears to have run its course and muni CEFs are beginning to recover, but are still well below their levels 12 months ago. To see how this bear market has affected reward versus risk, I re-ran the analysis with a 12-month look-back period. The results are shown in Figure 4. As you would expect, the outcome was not pretty, with all the funds booking negative returns over the period. Sharpe ratios are not useful for negative returns but the chart does show that both the ETFs (MUB and IEF) outperformed most of the CEFs. For the CEFs, MUI and MYI had the best returns.

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Figure 4: Risk Versus Reward Municipal CEFs Past 12 Months

Does the recent sell-off represent a buying opportunity for muni-CEFs? Only time will tell but I believe these CEFs deserve serious consideration in taxable accounts. With the exception of last year, combining the CEFs into a tax-exempt portfolio has generated good risk-adjusted returns with moderated risks. If you would rather select individual CEFs, I liked both MUC and MYI.

COMMENTS

Comments (6)

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JerbearComments (449)
The default rate on Muni bonds has always been sensationalized by the media. I won't mention the name of the lady who drove the muni market down a couple of years ago on a totally bogus call. She should have her licensed revoked in my humble opinion.



According to Moody's, investment grade bonds in 2013 had 23 defaults out of 21,523 for a default rate of .107%.



Here is a link to the data:
http://bit.ly/1msnBnz


Speculative grade muni bonds defaulted at a 2.1% rate. Most CEFs are limited so that no one bond can be more than 2% of the portfolio so the risk of a bond default effecting the fund is miniscule.


I have invested in Muni CEFs for years and have watched them sell off due to media hype when the market is perfectly fine. I sold and bought back again when they hit bottom. I am typically a buy and hold investor but these muni moves are predictable. When you hear the media spewing bad press about munis your sell. When they go quiet you buy.


Thank you for another interesting article John.

21 Apr, 01:45 PMReply! Report AbuseLike1


uiopuiopComments (12)
Jetbear,
So do your try and build sort of a ladder fund of CEF muni's? Holding for that long term gain/loss while collecting the dividends? I have been playing these funds for some time and see the same sort of thing that you are talking about. To go off topic do you also go in to CEF's that hold BDC's?

21 Apr, 02:10 PMReply! Report AbuseLike0


JerbearComments (449)
I choose my muni CEFs based on discount and yield and make certain it is diversified across states and types of bonds. I never buy a fund that doesn't have at least $250M in assets for liquidity purposes. I typically own from 3 to 7 funds. It doesn't have to be any more complicated than that in my opinion.



I have been looking at BDCs and MLPs but don't own any at this time. Some of my CEFs do hold MLPs in their portfolio such as SCD. It may hold some BDCs as well.

21 Apr, 03:17 PMReply! Report AbuseLike0


uiopuiopComments (12)
Interesting work, and comments. I'm holding some of your findings. In my muni portfolio. True last year was tough, but if you believed in such a portfolio, as I do, you did some tax loss harvesting. That seemed to work last year well before Nov. of 2013. I bought some funds back after the thirty day rule.They have been doing very well since.
You have to remember what fear was being spread all the way from the presidential elections to Buffet dumping muni's to Meredith Whitney's comments state budgets ect.. But look at those funds now. A Portfolio made up of cef muni's is a nice way to offset MRD's for IRAs for those getting close to 70. It give a flexibility to help offset taxes. You can take money out of the IRA and pay the taxes now and set up a muni fund to lower those MRD's in the future. The fund can be used as a device or a bucket to help if you a down year in your IRA. We will not always have years of gains like the last couple in the market. Tax free is a great help. The one nice part is that those dividends don't hit you on the AGI of your 1040. Like any other fund you do have to monitor them. But that tax effective dividend rate helps.

21 Apr, 02:00 PMReply! Report AbuseLike0


7of9Comments (274)
Duration of 10 years and leverage based on short term rates is a deal breaker for me. As short term rates rise next year, cost of leverage goes up causing distribution cuts.



I prefer high yield muni funds (OEF or ETF) with no leverage used.

21 Apr, 03:14 PMReply! Report AbuseLike0


ShoemouseComments (51)
You cannot consider a municipal CEF without factoring in leverage. Current leverage costs are low but the threat to increase short rates means a threat to dividends and capital. I am not saying that is coming, just that the risk of permanent capital loss is quite high if one believes higher rates are in our future.
There are a few unleveraged muni CEFs, ,like NNY, but they are older with high coupon bonds rolling off.
It is wiser to own both funds( including open-end funds)and individual bonds if you can do your homework. Each has their good points. Open end funds allow for internal compounding not easily accomplished with efts, cefs, and individual bonds.
But there too you get a perpetual portfolio of usually longer duration. Unlike the treasury market most muni debt is long as it funds long dated assets so funds have to where the yield and supply are located.
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