Everybody "knows" that folks in high tax brackets should hold municipal bonds in their portfolio. Right?
I've seldom met a holder of municipal bonds who weren't extremely proud of their accomplishment. After all, they're getting growth at the expense of Uncle Sam. That just has to be good.
But the truth is that muni's may actually create more tax problems than they solve. Other tax strategies might work better.
Just exactly what is a municipal bond?
Munis are issued by states, government agencies, and municipalities. The IRS, in an effort to encourage financial help for these entities provide that the interest on these bonds is (usually) exempt from federal income taxes. If a muni is issued by a state, the interest is usually exempt from state taxes, in that state, as well. Here are just a few of the problems with muni bonds.
Municipal bonds are not carrying terribly attractive yields right now. This means that it usually doesn't make sense to invest relatively small amounts in them. Lets say you invest $100,000 in munis paying a 5% coupon. That's $5,000 a year in non-taxable income. Assuming a 15% tax rate you've just saved $750. But an average returning mutual fund would have netted you $5950 after taxes, without all the other risks detailed below.
Interest Rate Risk
If interest rates go up sharply you'll lose with munis. Suppose you have a muni bond paying 5% and interest rates return to their normal average of 6%. Who's going to want to buy that bond from you? Nobody, and you'll end up selling at a deep discount.
Risk of Default
Have you heard of Detroit? Stockton, California? Your city? These are cities who are in default on their obligations. In case you haven't noticed cities and states are in trouble financially. Many muni bonds may never be paid.
Many bonds have a "call" provision which enables the issuer to buy back these bonds before maturity. If interest rates go up you're stuck with devalued bonds. If rates fall the issuer can call the bond which will force you to reinvest at lower rates. Heads he wins, tails you lose.
Municipal bonds are subject to the claims of your creditors.
Retirement Plan Risks
If you put municipal bonds inside a deferred retirement plan, the earnings will be taxed no matter what, even if the growth came from munis.
If you move to another state your state muni may suddenly be taxable in your new state.
The interest from some munis is subject to the Alternative Minimum Tax. Check with a tax professional before obligating if you think AMT exposure is a possiblity.
Exposure to Estate Taxes
Any municipal bonds that you hold at death will become part of your estate, thereby subjecting them to possible state taxes.
Are they worth the risk?
Generally, if you're not in one of the upper tax brackets the answer is no. If your portfolio is heavily loaded with munis you might want to have a chat with a professional to determine if your assets would be better allocated elsewhere.
Till next time,