A $1,000,000 Municipal Bond Dilemma

Those of you who follow my writings at About.com, a division of The New York Times, know that I’ve written about municipal bonds at the Investing for Beginners site including one article that detailed some ways to help you determine if a specific municipal bond was “safe”.

Municipal bonds are bonds issued by state and local governments for projects that help build the civilization such as schools, roads, bridges, and hospitals. As a reward for investing in these types of projects, which typically offer a lower return than corporate bonds, the government doesn't charge the investor any tax on the interest income he or she earns. This helps attract private money to public projects.

At the wedding this weekend, I was discussing a family friend, who shall remain nameless, who is in his 80′s and has more than $1,000,000 parked in municipal bonds.  As many of you know, this means he earns tax-free interest income for investing in projects such as schools, hospitals and roads, which means he doesn’t pay a single penny to the state or Federal government as a reward for helping build the nation’s infrastructure.

The problem this friend was running into was he had only a few children, and could only transfer $13,000 to each of them annually without running into gift tax consequences.  If he had been married, he could have doubled that to $26,000 but he is a widower and doesn’t want to get remarried at his age.

He had a common dilemma faced by many successful savers and investors: By the time he grants his children their gifts each year, he has only parted with a portion of his annual interest income from the municipal bonds and still hasn’t transferred any of his actual municipal bonds or his real estate portfolio, which includes buildings in the Midwest!

That means he isn’t getting any of the principal value of his estate transferred.  Given his total asset size, he is facing the possibility of getting hit with a 55% estate tax above a certain amount once the Bush tax cuts are rescinded.

The Incentive System the Government Has Created Is Going to Result in Him Liquidating Municipal Bonds and Stopping Future Investments

As a result, he is trying to figure out how to stop investing and start transferring.  Those of you who think that tax policy doesn’t directly influence the quality of everything from highways to school buildings, this is evidence that you are clueless because these are the conversations people have behind closed doors. Take a moment to think about what that means for civilization …

If he wasn’t facing the dilemma he was, he would continue to reinvest all of his earnings because he may very well live another 10 years.  The millions of dollars he is now going to have to liquidate would have been more capital available for projects that involve construction jobs and city services! There is a reason the quality of our housing, commercial and industrial stock far exceeds that of countries such as Cuba.  You incentive-ize private investment and some people have a natural urge to stop consuming and start building instead.

He Was a Typical Millionaire and “Stealth Wealth” as a Majority of American Millionaires Are

Oh, and true to form, this particular family friend?  He never earned more than $50,000 from his day job, he lives comfortably, drives a nice car, gives a lot to charity, lives in a house valued at only a couple hundred thousand dollars and you would never know about his wealth by looking at him.

I told you in Misconceptions About Wealth and in The Importance of Frugality In Building Wealth that this was the case, just as you learned in one of my About.com articles, American Millionaires Back to Pre-Crisis Levels, 1 out of every 25 households is a millionaire.

Most of this is so-called “stealth wealth”, which are people who are likely to do things such as drive a Toyota, own a local plumbing business, and shop at Sam’s Club.  In fact, if you are the average American, you personally know 14 millionaires you just have no idea they are rich because they hide it (think about all the requests for money that they would have to deal with if people knew!).

It is also important to point out that this particular family friend, although being what many would consider rich and earning more than $10,000 per month from all sources including dividends, interest, rents, and Social Security, is not wealthy enough to qualify for the Capitalist Class.  To reach that level, your pre-tax earnings need to be at least $35,000 to $50,000 per month from your investments alone, which would rank you among the top 0.9% of household income in the United States.

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