April 30, 2013
Investing in Muni Bonds as Part of a Smart Retirement Plan
Municipal bonds are bonds issued by a local government, including a state, city, county, school district, public utility district, or any other governmental entity at or below the state level. These public entities will use the loans to fund public projects such as the construction of schools, hospitals, and highways.
Interest income earned by holders of municipal bonds is exempt from the federal income tax and state income of the state in which they are issued. While it may not make sense to keep municipal bonds in an IRA or other retirement savings account, which is also exempt from taxes, because the tax-free advantages would be wasted.
However, muni-bonds “can be an attractive alternative to money-market funds and certificates of deposit” for the taxable portion of one’s savings, according to the report.
In particular, high-income earners may benefit most from this investment. The average tax-free yield on municipal-bond funds was 1.75%, compared to less than a percentage point on taxable money-market accounts. For someone in the 35% income-tax bracket, that is equivalent to a 2.7% taxable yield.
Municipal bonds do not come without risks, however. Many have avoided munis since late 2010 and early 2011 “after dire predictions of mass defaults by municipalities and states,” which led to panic selling. However, municipal bonds have rallied as credit risk has improved. In the year ended March 31, according to investment researched Morningstar, investors have poured $42 billion into muni-bond funds. Additionally, a combination of increased demand from investors with a small supply from fewer issuers, muni bond prices have shot up. According to Morningstar, the average municipal bond fund had a total return (yield plus price appreciation) of 8 percent in 2012
There is a smart way to invest in municipal bonds while reducing interest-rate and default risk, according to Christine Benz, director of personal finance at Morningstar. One should stick with intermediate-term muni-bonds with a high percentage of their holdings in general obligation bonds. These include funds such as the Vanguard High-Yield Tax Exempt Fund, the T. Rowe Price Summit Municipal Intermediate Fund, and the Fidelity Intermediate Municipal Income Fund, according to Ms. Benz. These funds have annual fees of 0.2%, 0.5%, and 0.37% respectively.
One should note that tax-free interest earned off munis must be included in determining the portion of taxable Social Security benefits and calculating Medicare premiums. BUt while net investment income above $250,000 for couples and $200,000 for individuals will be subject to the new 3.8 percent Medicare surtax, income from muni bonds will not count as investment income when calculating the surtax.
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