A reader writes in to ask:
“I use Vanguard’s Total Bond Market Index Fund for my bond allocation, but I noticed that it doesn’t include any municipal bonds. Can you walk us through municipal bonds — how they work, who should own them, where you should put them (taxable account? IRA?), and which ones should you own (e.g. a general fund or a state-specific fund)?”
Bonds issued by U.S. states or municipalities are exempt from federal income tax. These bonds are referred to interchangeably as tax-exempt bonds, municipal bonds, muni bonds, or even just “munis.”
Because of their tax-exempt status, the market typically prices muni bonds so that they have lower yields than taxable bonds of a similar credit quality.
Who Should Use Muni Bonds?
Tax-exempt bonds only make sense when investing in taxable accounts. In other words, if all of your investments are in tax-sheltered accounts — 401(k), IRA, etc. — your investments are already protected from taxes, so there’s no reason to accept municipal bonds’ lower yields.
But even for investors who can’t tax-shelter all of their investments, muni bonds still aren’t necessarily the best bet.
Because of stocks’ built-in tax-efficiency (due to the maximum 15% tax rate on dividends and long-term capital gains), it generally makes sense to tax-shelter all of your bonds before tax-sheltering any of your stocks. As a result, municipal bonds typically only make sense if:
- Your desired bond allocation is larger than the amount of tax-advantaged space you have, and
- You’re in a high enough tax bracket that your after-tax yield on taxable bonds would be less than the yield on muni bonds of similar credit quality.
Example: James has $300,000 in a taxable account and $100,000 in an IRA. His desired allocation is 60% stock, 40% bond (that is, $240,000 stocks, $160,000 bonds for his $400,000 portfolio).
Even after James invests his entire IRA in bonds, he still needs to own $60,000 of bonds in his taxable account in order to satisfy his desired bond allocation. If James’ marginal tax rate is high enough, muni bonds could provide a higher yield than the after-tax yield on similarly-rated taxable bonds.
Of course, as with all broad investing guidelines, there will be exceptions. For example, an investor in a high tax bracket might want to own muni bonds in a taxable account and stocks in her retirement plan at work if the retirement plan has inexpensive stock funds but only super-high-cost bond funds.
Should You Own a State-Specific Muni Bond Fund?
While municipal bonds are exempt from federal income tax, they’re usually subject to state income tax. However, if you buy a bond issued by your own state or by a governmental body within your state, the bond will usually be free from state income tax as well.
State-specific muni funds (e.g., Vanguard California Intermediate-Term Tax-Exempt Fund) exist in order to invest in bonds within a particular state to take advantage of this exemption from state income taxes.
So, if you have a high state income tax rate, there’s a significant tax advantage to sticking with muni bonds from your own state. The downside is that you’d be sacrificing some degree of diversification.