By Greg Hart, CFP®
Investors seeking income from their safer investments have had a tough time doing that the past few years. Interest rates have been at record lows and, because of economic weakness, are unlikely to go much higher anytime soon. If you need your investments to generate income, learn how tax-free municipal bonds can be a good option while also delivering tax benefits.
Basics Of Municipal Bonds
Municipal bonds, or “Munis,” are issued by states, counties, and cities to fund their everyday operations, as well as to raise money to pay for special projects such as a new stadium or highway, or a university’s development project. The municipal bond market is huge, with more than $3.5 trillion in outstanding debt in the U.S.
To encourage investors to buy municipal bonds, the government makes them exempt from most federal income taxes, and potentially state income taxes as well, when purchased by a resident of that state. As an example, because New Jersey is a relatively high-tax state, investing in local municipal bonds becomes potentially even more attractive.
Because of the tax benefit, municipal bonds usually pay investors slightly smaller rates of interest than other taxable bonds, such as corporate bonds. Still, once your tax rate is factored in, municipal bonds may be the better choice. Which should you invest in? A trusted financial advisor can help you run the numbers.
Why Consider Municipal Bonds?
Many retirees who look to their investments to help fund their retirement are frustrated by the low rates offered by bank savings accounts or Treasuries. Municipal bonds can be a solid option for retirement income while providing greater flexibility than tying up your money in a CD or an annuity.
If you are not retired but invest through a taxable brokerage account, consider municipal bonds as an option for the fixed-income portion of the account to minimize what you have to pay in taxes. Municipal bonds provide a good way to preserve your principal while generating tax-free interest.
Tax Advantages of Municipal Bonds
Municipal bonds hold a few tax advantages over corporate bonds. While you may earn slightly higher interest on an equivalent corporate bond, you will have taxes to pay on the interest and, net after tax, the equivalent municipal bond will probably provide a better net after tax yield.
When you invest in a local municipal bond, it will usually also be exempt from your state’s income taxes – always check your local tax laws to be sure. Several U.S. states have no income tax, so exemption from state taxes will not offer an advantage in those particular states. On the positive side, residents of states without income taxes can buy muni bonds from any state and remain 100% tax-free.
Muni bonds are often a good investment for people with high incomes, such as business owners and professionals whereas an individual in a low tax bracket or living in a state without income taxes will not benefit quite as much. For those in the highest tax brackets, be aware of alternative minimum tax (AMT) issues. Look to invest in municipal bonds that are not subject to AMT such as public-purpose municipal bonds.
Lower Default Rates
Another advantage that municipal bonds have over corporate bonds is a low history of default. According to Moody’s (bond rating service) the annual municipal bond default rate was about 0.03% between 2009 and 2014. Conversely, the corporate bond default rate has been about 2.5% per year.
Studies indicate that many municipalities in the United States have improved their credit ratings since the 2008 financial crisis. However, this improvement does not mean that default risk has been, or will be, eliminated in the future. Therefore, careful selection and due diligence is important when choosing the right municipal bonds for your portfolio.
How To Invest In Municipal Bonds
If you want to buy individual municipal bonds, you can do so via a brokerage account. Or, you can purchase a mutual fund or ETF that invests in municipal bonds. Doing so lets you invest a smaller amount up front while getting greater diversity in what bonds you are invested in. It’s worth seeking out that diversity because while most municipal bonds are safe investments, there have been municipalities that had trouble making their debt payment. Economic stress is increasing for local governments because of the effects of COVID-19. A trusted financial advisor can help you sort through your options.
Municipal Bonds And Your Portfolio
Are municipal bonds right for your portfolio? They can be a good option if you are seeking both income and a way to limit the taxes you pay on that income. We at Haddon Wealth Management can help see whether muni bonds fit into your overall financial plan. To schedule a complimentary “Get Acquainted” meeting to describe our services and to see if our services are right for you, call us at (856) 888-1744 or contact us online.
Gregory M. Hart, CFP® is the founder and managing director of Haddon Wealth Management, LLC, a registered investment advisory firm that provides comprehensive wealth management (in-depth financial planning and sophisticated investment management) for clients who value a relationship-driven approach that delivers customized solutions. Based in Haddonfield, New Jersey, Greg works with clients throughout the Delaware Valley, as well as nationwide. To learn more, connect with Greg on LinkedIn, visit our website at www.haddonwealthmgt.com, or call (856)-888-1744 to begin a discussion.