By John Gerard Lewis
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Retirees normally buy municipal bonds for tax-free income. Indeed, the tax-equivalent yields of munis can regularly exceed that of taxable bonds, especially in the highest tax bracket. But investors who don't yet need interest income to live on can also wisely buy them in an IRA.
Yes, there's a twist coming: No one would ever consider buying a muni in a tax-deferred account, right? Wouldn't the IRA's tax-deferral benefit be unnecessary for a bond that is already tax free?
Of course it would be, and that's why you wouldn't buy a tax-free muni in your IRA. Instead, I'm suggesting that you put a taxable muni in it.
It's a revelation to many that some municipal bonds are taxable. And with that taxable status comes a higher yield-to-maturity than on tax-free munis. And if both are bought outside of an IRA or other tax-deferred account, the tax-free muni might well do better on an after-tax basis.
An example: The typical seven-year, upper-medium-grade, tax-free municipal is currently yielding around 2.7% to maturity, while a comparable taxable muni is yielding about 3.1%, a difference of 0.4%. In the 39.6% tax bracket, the tax-equivalent yield (TEY) for the tax-free bond is about 4.7%.1 That's a 52% yield advantage over the taxable bond (4.7% vs. 3.1%).
But if the taxable muni is bought inside an IRA, its interest income becomes tax deferred, and its TEY shoots to 5.4%1, comparable to the 4.7% TEY for the tax-free bond bought outside of the IRA. Granted, tax on the IRA muni income will have to be paid when withdrawn someday, but that's the case with any income earned inside an IRA. It's not tax free, but it is tax advantaged.
Besides, this analysis is not to demonstrate that either type of municipal bond is preferable to the other. Rather, it is simply to show that buying taxable municipals can be especially beneficial when bought inside an IRA.
It's a particular opportunity for people who want to invest in the debt obligations of local government entities, but who don't want to alter the composition of their non-IRA portfolios. These people would not be buying munis for the typical purpose, e.g., retirement income, but rather for an increased exposure to municipal bonds.
This is the very reason I've been buying high-grade, taxable munis2 in our IRA accounts lately, some of which are:
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Kane, McHenry, Cook and DeKalb Counties (Ill.) School Dist. 300, due 12/1/21, cusip 484080ME3. Moody's Aa3; TEY to maturity (at purchase): 4.522%.1
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Washington State Motor Vehicle Fuel Tax, due 8/1/23, cusip 93974CPJ3. Moody's Aa1; TEY to maturity (at purchase): 4.437%.1
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McComb County (Mich.) Limited Tax – Retirees Health Care, due 11/3/23, cusip 554885J38. Moody's Aa1; TEY to maturity (at purchase): 4.531%.1
Now, why might someone necessarily want an exposure to taxable munis when high-grade corporate bonds offer similar yields? Both have a place in a fixed-income portfolio, but municipal bonds are backed by the taxing authority of the city, county, school district or other entity that issues them. Corporations have no such confiscatory power.
Bear in mind that this broad taxing power applies to general obligation municipal bonds, as opposed to municipal revenue bonds that rely upon a specific source of revenue, such as receipts from turnpike tolls, stadium receipts, etc. I've never bought individual-revenue bonds. The relative risk isn't worth it to me.
And it always bears mentioning: I much prefer individual bonds, which promise a full return of principal on a specific date in the future, over bond funds, which don't.
1Based on a 39.6% federal tax rate and the 4.6% income tax rate of my home state, Kansas.
2 In the parlance of the investment world, "municipal bonds" include those issued by states, counties and other political subdivisions, not just cities.
