What are Municipal Bonds?
Municipal bonds, or “munis”, are bonds that are issued by state and local governments. They are unique in the fixed income investment world because they provide investors with tax free income.
Why Municipal Bonds?
Investors will generally say that these bonds have several advantages over other fixed income investments:
First – Tax Free Income. This is covered in more detail below because exactly how tax efficient munis are will depend on the bond you buy and the state you live in. However, interest that is received from municipal bonds does not count as taxable income for federal tax purposes.
Next – Higher returns. Muni bonds typically have a higher yield than US Treasury Bonds. While this is due to the fact that munis are riskier than treasury bonds, compared to other fixed income investments, municipal bonds are generally safe.
Are Municipal Bonds Tax Free?
Municipal bonds are typically described as being “tax free” – But what does that really mean?
The interest you receive from a municipal bond is not taxed at the federal level. This differs from interest you receive from a corporate bond, that is taxed at your federal income tax rate.
However, municipal bond interest does count towards your MAGI, or modified adjusted gross income. MAGI is used to calculate federal benefits such as your health care premium credit, or whether you can save in a Roth IRA.
This is an important and often misunderstood part of municipal bond’s tax treatment. While the interest is not subject to federal income tax, the income from these bonds do count as income for other purposes!
Where the tax treatment of these “tax-free bonds” gets more complicated is how the interest is taxed at the state level. In general, if the bonds are issued in your state, they are not subject to your state income tax.
For example, lets say you live in California and have $10,000 invested in 2 bonds:
A New York muni bond that has a yield of 2%,
and then a California muni bond that has a yield of 1%.
For Federal tax purposes, none of this interest will be taxed as income.
In the state of California however, the interest from the New York muni bond IS subject to state taxes because it is an out-of-state bond.
If you are looking for a more detailed example of how state taxes and municipal bonds create financial planning opportunities, here is a guide we have for clients looking at Iowa Municipal Bonds as investments.
Lastly, know that there is a lot of fine print on state tax treatment of these bonds. Even if a muni bond is issued in your state it may not be exempt from your state taxes.
For example, here is one municipal bond that is still subject to state taxes even for residents of Iowa:
So, read the information about the bond carefully before investing.
Should You Invest in Municipal Bonds?
Municipal bonds are good investments for those in high income tax brackets, and for those who live in high tax states.
When comparing a municipal bond investment to a regular bond investment, you should calculate a tax equivalent yield based on your income to determine what is best. Don’t know how to do that? We have a tax equivalent yield calculator here!
Because municipal bonds are tax free, they generally have lower real, after-tax interest rates for those in lower tax brackets.
How to Invest in Municipal Bonds?
As you evaluate if municipal bonds are right for you, consider a few things:
First, can you use a municipal bond ETF or mutual fund?
A fund will make diversifying much easier, since the fund likely owns hundreds or thousands of different bonds.
However, funds also come with added expenses. Make sure you find a fund with a low expense ratio.
If you find a decent low cost fund to use, make sure that it actually has municipal bonds from your state. Remember, income from out of state municipal bonds will be taxed at the state level.
So, if you live in California, it is easier – Vanguard and a few other companies offer California-only muni bond funds. For example, VCIAX.
However, if you live in another state, lets say Iowa – Vanguard does not have a Iowa specific bond fund. You can still buy a Vanguard municipal bond fund, but the interest will all still be subject to state taxes.
When to Buy Individual Muni Bonds
If you are from Iowa (or any other state that does not have state-specific municipal bond funds) and want municipal bonds that are exempt from both state and Federal taxes, you need to buy individual Iowa municipal bonds.
That means searching through a long list of individual bonds, and finding the ones that are right for you:
This requires a lot more work, and probably a lot of money to make worth while. Because many of these investments have minimums of $5,000 or more, you will want to have a lot of money devoted to the bonds available to ensure you remain diversified.
Best Municipal Bond Funds
If you are happy with a general muni bond fund that hold bonds from many states, there are some very good options:
The largest municipal bond mutual fund is Vanguard’s ” Vanguard Intermediate-Term Tax-Exempt Fund (Ticker: VWITX). The fund has over $86 billion in assets, with an expense ratio of just 0.17%
There are a few better ETF options available:
iShares National Muni Bond ETF (Ticker: MUB) has over $26 billion in assets, with an expense ratio of just 0.07%.
Vanguard also has an ETF, the Vanguard Tax-Exempt Bond ETF (Ticker: VTEB) that has $13 billion in assets and an expense ratio of 0.06%.