The Bush tax cuts are pre-set to expire at the end of this year. If nothing is done before then, taxes will increase for everyone earning more than $37,450 a year. So far, nothing has been done.

On May 23, 2003, Congress signed the Jobs and Growth Tax Relief Reconciliation Act into law.  This law set forth lower personal income tax rates for most tax brackets starting in the 2003 tax year.

However, these revised rates have a fast approaching expiration date: December 31, 2010. Unless Congress acts, tax rates will automatically revert to pre-2003 rates at the end of the year.

While Congress hasn’t done anything yet, the Obama administration’s proposed 2011 budget stipulates that current tax rates will expire on only those making $250,000 or more per year. Assuming that outcome, tax rates on those currently in the 35% bracket as well as many in the 33% bracket will increase to 39.6%.

#-ad_banner-#What does that mean for income investors?

Since interest income is taxable at personal income tax rates, higher wage earners will pay a greater chunk of interest income to Uncle Sam. However, there is one kind of yield that actually goes up when taxes go up: a taxable equivalent yield.

Tax free municipal bonds
Municipal bonds are bonds issued by states and cities as well as local government and various publically owned entities. Municipal bonds pay interest that is free from federal income taxes (and state taxes if held in the state of residence). When taxes rise, so does the relative value of tax free income.

Taxable equivalent yield (TEY) is the yield that must be earned on a similar taxable investment in order to maintain the same after-tax return paid by tax free municipal bonds. TEY can be determined by dividing a tax free yield by one minus the current tax bracket. For example, someone in the 33% tax bracket earning 6% tax-free would have a TEY of 8.96% (6 /(1-0.33)). That means a person earning 6% tax-free would have to earn 8.96% in a taxable investment to keep the same after tax return.

To illustrate the affect of rising tax rates, here are the current and future TEYs for someone currently in the 33% bracket if taxes rise to the proposed 39.6%.

Be selective
While the value of tax-free income is about to increase, investors need to be aware that municipal bonds, while safe, have more risk today than in the recent past. As a result of the financial crisis and the following recession (as well as fiscal mismanagement), states and cities across the nation are facing massive unfunded pension liabilities and soaring deficits.

In fact, as Carla Pasternak, editor of StreetAuthority’s High-Yield Investing, pointed out in a recent article, more than 40 states will run budget deficits in 2010. Many municipalities are on an unsustainable fiscal path. The months and years ahead there could see increases in municipal bond defaults. [Read: How to Hide from the Dividend Tax Increase ]

Municipal bond investors need to be cautious. A good way to offset the current risks is with a well diversified portfolio of bonds, which offsets risks associated with any one issue. Investors should also mind the credit quality of the bonds or funds in which they invest as well.

Action To Take –> Muni bond funds are a great way to position for rising taxes. They let you take advantage of rising taxable equivalent yields while mitigating risk in the municipal market.

Carla’s top recommendation is a closed-end fund that generates income from more than 400 U.S.-based municipal bonds and could soon pay an eye-popping taxable-equivalent dividend yield of 11.8%. She calls it her “Income Security of the Month” for September 2010.

This fund offers everything an income investor could ask for: a high yield, monthly distributions, growing dividend payments, a dividend reinvestment plan… and best of all, a tax-free status that lets you completely avoid the 2011 tax increases. As we go to press, this fund sits at the top of Carla’s “Buy Now” list. [Read More: “Income Security of the Month” for September 2010”]