Are Municipal Bonds Right for You?

No one likes paying taxes. We all want to minimize the amount of taxes that we owe, so we’re always looking for any tips and tricks we can find. Municipal bonds, or munis, often seem like a great solution since they’re billed as being tax free (which we’ll talk about in a bit). Unfortunately, everyone else thinks so, too, which means that their prices reflect their tax advantages.

Start with our article Do You Understand How Bonds Work?

Now, this doesn’t immediately disqualify munis as a great tool for retirement investors, but it does mean that you need to be careful about how you use them.

One of the first things that you should be paying attention to if you’re thinking about munis is your asset location. By and large, because bonds are so tax inefficient, you generally really want to put them in one of your tax advantaged accounts. Bonds typically kick off a huge amount of income, and keeping them in your tax advantaged accounts – especially your tax deferred accounts – means that you don’t need to pay taxes on that income. Unfortunately, sometimes your asset allocation has more bonds than you have space in your tax advantaged accounts. This is where we start our conversation about munis. Because of the tax advantages that munis offer (and that you’re paying for when you buy a muni) they really don’t belong in a tax advantaged account. All of the tax benefits are lost if you buy munis in your IRA, so you really only want them in your taxable portfolio. Munis are essentially a back up plan if you need to put bonds in your taxable account.

Let’s talk about that tax benefit for a minute. It’s true that muni bonds are often “tax free”, but there are a lot of qualifiers on that. First off, while all munis are tax free at the federal level (in contrast to treasury bonds that are tax free at the state level – taxes seem intentionally obtuse sometimes, don’t they?), in most states they are only tax free within the state they were issued in. Some examples will illustrate this. I live in Maine. If I buy a muni issued by a town in Maine, that bond is tax free at both the state and federal level. I just don’t owe any taxes on the money coming off of that bond. But let’s say that I buy a muni bond from California. Maine isn’t going to give me the state tax exemption on that bond. They’ll still want their cut, even though the bond is tax free at the federal level.

Another issue to be aware of is the Alternative Minimum Tax, or AMT. If a bond is not for purely governmental purposes, what are called Private Activity bonds, they are subject to the AMT, even if they aren’t subject to regular taxes. As you might imagine, this can negate some of the tax advantages of munis.

With all of this in mind, we need to decide if it makes more sense to use munis or regular bonds in your taxable account. It’s important to remember that the tax benefit of munis is not evenly distributed. When you’re looking to buy a muni bond, you’re competing with all sorts of people who are at the top end of the tax burden in their state, and therefore value the tax benefits of munis more than you might. This goes double if you are looking at an out-of-state bond. Say that you are looking at a bond from California, but you aren’t a California resident. Well, everyone in the state of California gets a state tax benefit that you don’t. So they are going to be willing to pay more for the bond.

This is where the Tax Equivalent Yield comes in. This is just a fancy way of saying you need to check which makes more sense on an after-tax basis: to buy a muni, or to pay the taxes on a regular bond. If your after-tax yield is higher with munis, use them. If your after-tax yield is higher with regular bonds, then use those. It’s pretty straightforward.

Municipal bonds can be a clever tool, but you need to use them appropriately to get the benefits you’re expecting.

To learn more about the risks you should be focusing on in your retirement plan, read the 7 Risks of Retirement Planning.