Earn Tax-free Income from Your Investments with Municipal Bonds
published by Investing.com October 30, 2024 https://www.investing.com/analysis/earn-taxfree-income-from-your-investments–consider-municipal-bonds-200653607
Like all bonds, municipal bonds are trading at much higher yields on an absolute basis than in decades. A big part of that is the recent rate-hiking cycle that the Fed has embarked upon to curtail inflation, which was at 40-year highs. So, we have a much different yield environment overall, which creates tremendous opportunities for fixed-income investors who can buy and hold bonds and clip coupons over the long run.
The Federal Reserve has indicated that further progress on inflation could lead to key changes in its policy statement that would pave the way for additional rate cuts in the remainder of this year and next year. Directionally, this can also be a positive for bond investors of any type, whether it’s a taxable or tax-exempt bond fund.
Why consider municipal bonds as opposed to other types of bonds?
Most investors looking for ways to negate their overall tax bill find the tax-free income of municipal bonds very compelling. In 2017, the Tax Cuts and Jobs Act enacted legislation bringing down overall tax rates. That legislation is set to expire at the end of 2025, which has lifted the demand for investors as ways to find tax-free investments.
There have also been several states that have changed tax laws, especially those high-income-tax states, where corporations are now looking at municipal bonds as a way to benefit from tax-free income as well. So, there’s demand out there for tax-free municipal bonds.
Bond prices are, in part, often driven by supply and demand, and supply has not been as much as demand lately when it comes to municipal bonds. However, we believe continued higher demand will continue.
Keep More of What You Earn After Taxes
The crucial consideration when considering when you should invest in municipal bonds is that it’s not what you make on a bond—it’s what you take home after taxes. The tax equivalent yield is what investors should be thinking about when considering whether or not they should invest in municipal bonds. Relative to what you can get from taxable bonds, the taxable equivalent yield for municipal bonds becomes much more compelling. So really, there’s a solid case to be made today to add municipal bonds because of the after-tax impact.
Don’t Forget the Diversification Benefit
Municipal bonds are debt securities issued by states, cities, counties, and other governmental entities to fund day-to-day obligations and to finance capital projects such as building schools, highways, or sewer systems.
By purchasing municipal bonds, you are, in effect, lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return on the original investment, or principal.
Generally, the interest on municipal bonds is exempt from federal income tax. The interest may also be exempt from state and local taxes if you reside in the state where the bond is issued. There are a lot of high-credit quality (investment grade) municipal bonds that can be purchased at attractive rates today. These bonds should be used in taxable accounts and not retirement accounts, which are tax-advantaged accounts.
So, as with all portfolios, diversification is an important consideration. Municipals offer compelling features that differentiate them from other securities, such as stocks and bonds. They have different credit and liquidity features, and there are several opportunistic ways that investors can include actively managed municipal bonds in a portfolio.
David Rosenstrock, CFP®, MBA is the Director and Founder of Wharton Wealth Planning (www.whartonwealthplanning.com). He earned his MBA from the Wharton Business School and B.S. in economics from Cornell University. He is also a CERTIFIED FINANCIAL PLANNER™.
