Q: I make enough money to where I am getting tired of paying taxes. Since the so-called tax reform was passed, I have fewer deductions to take. Should I start investing in municipal bonds?
A: Municipal bonds can be a great source of tax-free income when they are used correctly. However, whether or not muni bonds make sense for you depends on several things, including your overall investment objectives and your personal marginal tax rate.
Before you buy muni bonds, consider carefully if bonds generally should be part of your portfolio. Bonds might fit for several reasons. First, bonds can reduce portfolio volatility. Bond price volatility is typically much less than the volatility of stock prices. In addition, bond prices usually exhibit low correlation with the movement of stock prices.
Another reason you might want to own bonds is to increase portfolio income. In today’s market, dividend-paying stocks from high quality companies typically pay dividends somewhere around 1.8% of their market price. In contrast, an intermediate maturity bond issued by a similar company would probably yield twice that amount.
Finally, bond investors have a more senior claim on the assets of the issuing company. This means you as a bondholder are more likely to recover more of your investment in the event of a bankruptcy than you would as a shareholder.
Once you decide that bonds are a good fit, the decision of which type of bond to buy depends on the type of account you have and which type of bonds produce the best after-tax returns. Under normal circumstances you would never put a tax-free muni bond in an IRA. However, if you are working with a taxable portfolio, tax-free munis might make sense if their yield compares well with taxable bond yields. To make the comparison, we need to calculate the municipal bond’s taxable-equivalent yield.
Taxable-equivalent yield grosses up the muni bond’s tax-free yield to what it would be if it were taxable, enabling you to directly compare the muni bond yield with yields on taxable bonds. To calculate the taxable equivalent yield, divide the muni bond’s yield-to-maturity by one minus your marginal tax rate. For example, at the time of this writing, AA-rated California muni bonds with five years to maturity yield around 2.3%. If my combined state and federal marginal tax rate were 43%, the muni bond’s taxable equivalent yield would be 4.04%. A corporate bond of similar quality and maturity yields only 3.2%, so the muni bond is a more attractive investment.
But what if I were in a lower tax bracket? In that case, the muni bond would look less attractive. For example, if my combined state and federal marginal rate were only 20%, the muni’s taxable equivalent yield would only be 2.88%. In that case, you would be better off buying the corporate bond and paying taxes on the income.
The CPA or enrolled agent who prepares your taxes can help you get a good estimate of your marginal tax rate. If you prepare your own taxes, you can estimate your marginal tax rate using the IRS tax tables at www.IRS.gov.
One final word of caution: the municipal bond market can be treacherous. Because muni bonds are traded over-the-counter, prices are not transparent. At the same time, bond structures can be very complex. If you are going to invest in muni bonds, it pays to work with an advisor who has significant experience in this part of the market. For most people, a better approach would be to stick with a well-managed municipal bond mutual fund.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to: email@example.com