Investors often hear they need a diversified portfolio that includes both stocks and bonds. Municipal bonds, also known as "munis," are a popular type of bond because they offer tax-free income, but they aren't right for everyone.
Before investing in munis, it’s important to understand how municipal bonds work and how they are taxed. By the time you’re done reading this article, you’ll know if municipal bonds might be a good fit for your portfolio.
Let’s dive in…
A municipal bond is basically a loan to a local government or government entity. States, cities and counties borrow money from individual investors when they don’t have the money to pay for big projects up front. Projects such as:
Investors receive interest payments over a set number of years. When the bond matures, investors receive their original investment back.
There are two main types of municipal bonds:
While it’s possible to buy individual municipal bonds through a brokerage account, most people use municipal bond ETFs (exchange-traded funds) to purchase a bundle of bonds from different issuers. Municipal bond ETFs provide exposure across multiple issuers and regions, which can reduce risk.
Municipal bonds are generally considered a safe investment. Historically, munis have lower default rates than corporate bonds, especially high-yield corporate bonds. They are not risk-free investments, however.
Declining tax revenues or economic downturns can increase the possibility of missed payments or defaults. Municipal bonds are also subject to interest rate risk. This means the value of municipal bonds can drop even if the issuer remains financially healthy.
Both municipal bonds and treasury bonds are considered conservative fixed-income investments, but there are two important differences.
Treasury bonds are issued by the federal government. Interest payments are subject to federal income tax but are exempt from state and local taxes.
Municipal bonds are issued by local governments, and interest payments are typically tax-free at the federal level. As a result, municipal bonds can provide higher after-tax income for people in higher tax brackets (compared to treasuries).
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SOURCE: Fidelity
Tax-free bonds are beneficial for investors in a high tax bracket (compared to high-yield corporate bonds or other taxable bonds) because of their net yield after taxes.
The chart below from Charles Schwab illustrates this point using the Bloomberg Municipal Bond Index, a fund that has a 3.6% yield. If the income was taxable, an investor in the top tax bracket would pay 37% plus the 3.8% Net Investment Income Tax. But because the income on this fund is tax-free, the tax-equivalent yield is 6.1%.
Note: the chart below does not factor in state tax. Investors in high-tax states, such as California, receive a higher tax-equivalent yield than what’s shown below.
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SOURCE: Charles Schwab
As the chart above illustrates, municipal bonds can benefit investors in mid-range tax brackets as well. An investor in the 24% tax bracket receives a 4.7% tax-equivalent yield on a muni compared to a fully-taxable bond at the 24% tax rate. Again, that percentage does not account for state tax. If you live in a state with high income tax, the tax-equivalent yield will be even greater.
Triple tax-free bonds are exempt from:
How do you buy a triple tax-free bond? You have to reside in a state that issues municipal bonds that are exempt from state and local taxes (most municipal bonds are exempt from federal income tax anyway) and buy one of your state’s tax-free bonds. For example, if you reside in California and buy a municipal bond that is exempt from state and local taxes, your interest payments are triple-tax free.
If you reside in one of the seven states that don’t have income tax, you probably won’t be able to take advantage of a triple tax-free bond. There are exceptions, however. Please contact a financial advisor for more information.
Tax-exempt municipal bonds are generally best suited for taxable brokerage accounts. Holding tax-exempt bonds inside a tax-advantaged retirement account, such as an IRA or 401(k), may reduce or eliminate the value of that tax benefit.
Taxable municipal bonds, on the other hand, can be held in either taxable or retirement accounts. You read that right. Some municipal bonds are taxable. Taxable munis are less common than tax-exempt munis, but they do exist and can play a role in a diversified fixed-income strategy depending on current yields, tax rates and portfolio needs.
It is also important to understand that some private activity bonds can still be subject to the Alternative Minimum Tax (AMT). The AMT can create unexpected consequences for higher-income investors, which is why working with a financial advisor or tax professional can be valuable.
If your tax rate is 10%–12%, municipal bonds probably aren’t a good investment because the tax benefits are minimal. Corporate bonds, which offer a higher yield, will likely generate more income than munis, even after taxes.
Taxpayers in the 22% or 24% tax bracket should consider municipal bonds, especially if you live in a state with high income tax.
People who pay 32% or more in federal income tax receive the biggest benefit from municipal bonds.
Other types of investors who might consider municipal bonds include:
A financial advisor can help you do the math and identify the best type of bonds for your income and goals.
Many investors use municipal bonds for income, diversification and tax-efficient investing. But they aren’t right for everyone.
Potential advantages include:
Potential disadvantages include:
You don’t have to become an expert in default and interest rate risks or teach yourself how to calculate after-tax yields. One of our friendly and helpful financial planners can help you decide if munis are a good fit for your investment goals. Contact us online or give us a call at (415) 541-7774.
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Disclaimer: Assembly Wealth is neither an attorney nor accountant, and no portion of this content should be interpreted as legal, accounting or tax advice. Individuals should consult with an investment professional, or an attorney or tax professional regarding their specific investment, legal or tax situation.
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Tax-equivalent yield examples are provided for illustrative purposes only and are based on assumed tax rates and other factors that may not apply to all investors. Actual tax benefits, investment results, and after-tax returns will vary based on an investor's individual circumstances. The Bloomberg Municipal Bond Index is an unmanaged index that measures the performance of the U.S. investment-grade municipal bond market. The Index is not available for direct investment, and index returns do not reflect the deduction of fees, expenses, or transaction costs. All investments involve risk, including the possible loss of principal. Municipal bonds are subject to interest rate risk, credit risk, and market risk and may not be suitable for all investors.
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