Why Tax-Free Munis Belong Outside Your IRA

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Why Tax-Free Munis Belong Outside Your IRA

Buying municipal bonds (munis) may be a sensible approach to diversify your portfolio while receiving welcome tax advantages for many investors. However, if you want to buy these local government bonds for an individual retirement account (IRA), whether Roth or traditional—or, indeed, any other retirement account—you should wait. This is why.

Key Takeaways

  • The bulk of municipal bonds (munis) pay tax-free interest at the federal level.
  • These munis often provide a lower nominal return than similar securities due to their tax-free status.
  • Because most municipal bonds have an inherent tax advantage, there is no benefit to keeping them in an individual retirement plan, whether regular or Roth.
  • However, approximately one-third of munis are taxable, which may make them a better choice for a retirement plan.

What Is a Municipal Bond?

The name “municipal bond” suggests that these interest-bearing bonds are exclusively issued by municipalities. In reality, the term refers to bonds issued by any local authority, including counties and states. Other governmental agencies, such as school districts, port authorities, and housing authorities, may also issue “munis.” The proceeds from these bond offerings may be used for a number of purposes, including the construction of a new school, the construction of new roadways, or the rehabilitation of a sewage system.

Many munis are classified as general obligation (GO) bonds, which need voter approval to be issued. GO bonds are typically safer than corporate bonds since they are guaranteed by the taxation power of the government organization that issued them.

Other types of munis include revenue bonds, which are repaid with a defined income stream. This might be a stadium that charges admission or a local roadway that charges tolls. These are riskier since they are not backed by the issuer’s full faith and credit. To compensate, governments often pay greater rates of return.

Municipal bonds are unique in that they are issued with numerous maturity dates. As a result, one piece of the owner’s principle matures on a certain date, while other sections mature on separate dates. The interest rate might also fluctuate depending on the maturity date of the bond.

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Tax Advantages of Munis

Most municipal bonds have one distinct benefit over other debt instruments: their interest payments are tax-free at the federal level. If you reside in the state where they were granted, they are often tax-free at the state level as well.

Investors are ready to accept lower interest payments on tax-free munis since they are not contributing a part of their interest revenue to the government. Those in higher tax rates benefit from owning such bonds since their tax-equivalent yield—which accounts for the tax hit from other fully taxable bonds—remains relatively high. These bonds grow more appealing when the marginal tax rate rises.

The following calculation may be used to determine a muni’s tax-equivalent yield:

Municipal bond yield ÷ (1 − marginal tax rate) = tax-equivalent yield

Consider an investor in the 35% federal tax rate. Most bond interest income would be taxed at 35% for this person. A 5% yield on a tax-free muni, on the other hand, would have a tax-equivalent yield of 7.7%.

5.0% ÷ (1 − 0.35) = 7.7%

Assuming a same level of risk, this investor would choose a tax-free muni with a nominal yield of 5% over taxable bonds with yields of 6% or even 7%.

Avoid Tax-Free Munis in an IRA

Municipal bonds are deemed more appealing than fully taxable bonds that give somewhat higher yields due to their tax-free status, particularly if you are in the medium or high tax bracket. However, if you possess tax-free munis in a qualified retirement plan, the tax advantage of these debt instruments is negated.

This is because IRAs and Roth IRAs, as well as 401(k)s and other employer-sponsored plans, have tax advantages of their own. In fact, you’re receiving a bond with a lower return than similar securities and no additional tax advantage to compensate.

A typical IRA, for example, allows the account owner to deduct contributions from taxable income up to permitted limitations and collect tax-deferred profits in retirement. They must then pay regular income tax on any withdrawals made beyond the age of 5912. Because you obtain the tax break up front, even people who hold munis in an IRA must pay income tax on account payouts.

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How do Roth IRAs work? While there is no tax deduction for donations, depositors who are at least 5912 and have held the account for at least five years may make tax-free withdrawals. So, once again, investing in a tax-free bond does not provide you with an extra tax advantage.

Exceptions to the Rule

It’s crucial to note, however, that not all munis provide a tax break. According to Charles Schwab, around 30% of municipal bonds issued in 2020 will be taxable. The Tax Cuts and Jobs Act of 2017 has boosted their frequency.

These are often bonds that do not give a considerable advantage to the general public and hence fail to fulfill the federal criterion for tax-free bonds. Bonds used to pay new sports facilities or airports, or to strengthen a public pension system, are two examples.

As you would expect, taxable munis have larger returns than their tax-free counterparts, making them a better choice for IRAs. Withdrawals are still subject to ordinary income tax, but you get a greater interest payout. They are still backed by the government that issued them, which has traditionally made them safer than even similarly rated corporate offerings.

This rationale also holds true for private activity bonds. These bonds are used to finance assets like as high-speed rail networks and garbage disposal facilities, which then lease or contract them to private enterprises. While their interest payments are not considered regular income, they are subject to the alternative minimum tax (AMT), which many higher-income people must pay.

As a result, private activity bonds provide a greater return than tax-free bonds. In certain situations, storing these assets in a tax-deferred account, such as an IRA, may be advantageous. This is when a skilled tax counselor comes in handy.

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Why shouldn’t you put municipal bonds (munis) in an individual retirement account (IRA)?

The majority of municipal bonds (munis) pay tax-free interest at the federal level (and sometimes at the state level).As a result, their yields are somewhat lower than those of other taxable bonds. Because putting them in an IRA or 401(k) often does not give an extra tax advantage, there is no incentive to fill these accounts with lower-yielding bonds.

How do you calculate the tax-equivalent yield for a municipal bond?

To get the tax-equivalent yield on a municipal bond, use the following formula: 1 marginal tax rate municipal bond yield

Because everyone has a distinct marginal rate, the tax-equivalent return will change from person to person. The calculation may be used to examine if the tax advantages of muni bonds compensate for their lower yield when compared to taxable bonds.

Are all munis tax free?

No, in order for interest payments to be tax-free, a bond must fulfill specific Internal Revenue Service (IRS) conditions. Bonds that do not give a substantial benefit to the public are usually taxed since they do not fulfill that requirement. A private activity bond is a third form of muni that is not subject to income tax but is subject to alternative minimum tax (AMT) computations.

The Bottom Line

Municipal bonds (munis) may be an excellent investment, particularly if you are in a higher tax rate. However, in most circumstances, you’ll want to place tax-free munis in a taxable account since IRAs and 401(k)s would not give any further advantage.

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