David Lerner Associates: Should Muni Bonds Be Held in Retirement Accounts?

Muni bonds, meanwhile, offer their own built-in tax advantages: Interest paid on muni bonds is generally exempt from federal income tax, as well as state and local income tax for residents of the municipality that issues the bond. So holding muni bonds in a tax-advantaged IRA or 401(k) would be wasting their inherent tax advantages.

However, muni bonds could be a viable investment option for the taxable portion of a retirement savings portfolio. In 2012, the average tax-free yield on muni-bond funds was 1.75 percent — which is the taxable equivalent of a 2.7 percent yield for an individual in the 35 percent income-tax bracket. The average yield on taxable money-market accounts last year, however, was less than one percent.

Muni bonds may be especially attractive for high earners, given the recent increase in the top tax rate from 35 percent to 39.6 percent for couples earning more than $450,000 and singles earning more than $400,000. This essentially makes a muni bond’s tax benefits even more valuable. For an individual in the 35 percent tax bracket, a tax-free yield of 3 percent is the equivalent of a 4.6 percent taxable yield, but it’s the equivalent of a 4.97 percent taxable yield for an individual in the new top tax bracket of 39.6 percent.

In addition, muni bond income does not count when determining whether the new 3.8 percent Medicare surcharge that applies to net investment income above $250,000 for couples, or $200,000 for individuals, must be paid. Also keep in mind that municipal bonds are an income-generating investment. If an investor purchases a $100,000 municipal bond that pays 4 percent interest, he or she will receive $4,000 a year in potentially tax-free income.

It’s important to note that muni bonds are not risk-free. They are subject to credit risk, or the risk that the bond might be downgraded or the issuer might default and fail to repay the principal, and interest-rate risk, or the risk that rising rates could erode the bond’s price. The lower a muni bond’s rating, the higher the risk of a credit downgrade or default.

In late 2010 and early 2011, some experts were predicting a wave of muni bond defaults by states and municipalities, which was followed by some panicked selling by investors. However, this default wave hasn’t materialized, as many governments have cut their expenses, reduced services and raised taxes in order to balance their budgets. As a result, muni bonds have experienced a rally recently — $42 billion was invested in muni bond funds in the year ending March 31, 2013, according to Morningstar.

Material contained in this article is provided for information purposes only and is not intended to be used in connection with the evaluation of any investments offered by David Lerner Associates, Inc. This material does not constitute an offer or recommendation to buy or sell securities and should not be considered in connection with the purchase or sale of securities. Member FINRA & SIPC.