Why Tax-Free Munis Belong Outside Your IRA

There’s no benefit to holding municipal bonds in an IRA or a Roth IRA

Fact checked by Betsy PetrickReviewed by Ebony Howard

For a lot of investors, buying municipal bonds (munis) can be a smart way to diversify your portfolio and receive welcome tax benefits. However, if you’re thinking about purchasing these local government bonds for an individual retirement account (IRA), whether Roth or traditional—or, indeed, any other retirement account—you may want to hold off. Here’s why.

Key Takeaways

• The majority of municipal bonds (munis) pay interest that is tax free at the federal level.
• Because of their tax-free status, these munis normally pay a lower nominal yield than comparable securities.
• As most municipal bonds have a built-in tax benefit, there’s no advantage to holding them in an individual retirement account, whether traditional IRA or Roth IRA.
• However, nearly one-third of munis are taxable, and these might be a better fit for a retirement account.

What Is a Municipal Bond?

The term “municipal bond” implies that these interest-bearing bonds are issued only by cities. In fact, the moniker applies to bonds issued by any local government, including counties and states. Other governmental entities, such as school districts, port authorities, and housing authorities, also can issue “munis,” as they’re commonly known. The issuer may use the revenue from these bond issues for a variety of reasons, including to build a new school, construct new roads, or repair a sewer system.

Many munis fall under the category of general obligation (GO) bonds, which means that voters must approve their issuance. As they’re backed by the taxing authority of the government entity that issued them, GO bonds are generally safer than corporate bonds.

Other munis are known as revenue bonds, which are repaid by a specific revenue source. This could be a stadium that brings in licensing fees or a local highway that collects tolls. These aren’t backed by the full faith and credit of the issuer, which makes them somewhat riskier. To overcome that, governments tend to pay higher rates of return.

One of the unusual features of municipal bonds is that they’re issued with multiple maturity date. The effect is that one portion of the owner’s principal matures on a given date while other portions mature each on a different date. The interest rate also can be different for each maturity date associated with the bond.

Tax Advantages of Munis

Most municipal bonds have an advantage that sets them apart from other debt instruments: Their interest payments are tax free at the federal level. They’re often tax-free at the state level, too, if you live in the state where they were issued.

Because they aren’t paying a portion of their interest income to the government, investors are willing to accept lower interest payments on tax-free munis. Those in higher tax brackets tend to win out by purchasing such bonds, because their tax-equivalent yield—which takes into account the tax bite from other fully taxable bonds—is still relatively high. The higher the marginal tax rate, the more attractive these bonds become.

You can calculate the tax-equivalent yield for a muni by using the following formula:

Municipal bond yield ÷ (1 − marginal tax rate) = tax-equivalent yield

For example, take an investor in the 35% federal tax bracket. This individual would have to pay a 35% tax on interest income from most bonds. However, with a tax-free muni, a 5% yield would have a tax-equivalent yield of 7.7%.

5.0% ÷ (1 − 0.35) = 7.7%

Assuming a similar level of risk, a tax-free muni with a nominal yield of 5% would be more favorable to this investor than taxable bonds with a 6% or even a 7% yield.

Avoid Tax-Free Munis in an IRA

Because of their tax-free status, municipal bonds are considered more attractive than fully taxable bonds that offer slightly higher yields—especially if you’re in a middle or high tax bracket. However, if you own tax-free munis in a qualified retirement plan, you’re nullifying the tax benefit of these debt instruments.

That’s because IRAs and Roth IRAs—along with 401(k)s and other employer-sponsored plans—offer tax perks of their own. In effect, you’re getting a bond with a lower yield than comparable securities, and you get no added tax benefit to make up for it.

For example, with a traditional IRA, the account owner can deduct contributions from their taxable income, up to allowable limits, and accrue earnings tax deferred in retirement. They then pay ordinary income tax on any withdrawals after age 59½. Because you’re getting the tax write-off up front, even those who own munis within an IRA have to pay income tax on their account distributions.

What about Roth IRAs? While there’s no tax deduction for contributions, savers can make tax-free withdrawals if they are at least age 59½ and have owned the account for at least five years. So, again, you aren’t getting an additional tax benefit by investing in a tax-free bond.

Exceptions to the Rule

It’s important to realize, however, that not all munis offer a tax benefit. In fact, approximately 30% of municipal bonds issued in 2020 were taxable, according to Charles Schwab. Their prevalence has increased as a result of the 2017 Tax Cuts and Jobs Act.

These are usually bonds that don’t provide a significant benefit to the public at large and therefore don’t meet the federal criteria for tax-free bonds. Examples include bonds used to fund new sports facilities or airports or to solidify a public pension system.

As you might imagine, taxable munis generally offer higher yields than their tax-free counterparts, which can make them a better fit for IRAs. You still pay ordinary income tax on withdrawals, but you get a higher interest payment. They’re still backed by the issuing government, which has historically made them safer than even comparably rated corporate issues.

This logic also applies to private activity bonds. These bonds fund assets such as airports, docks, or wharves, which sell leases or contracts to private companies. While their interest payments are excluded from ordinary income, they’re still subject to the alternative minimum tax (AMT) that many higher-income households have to pay.

Consequently, private activity bonds also offer a higher yield than tax-free bonds. In some cases, there may be advantages to holding these assets in a tax-deferred account such as an IRA. Here’s where you need the help of a good tax advisor.

Why shouldn’t you put municipal bonds (munis) in an individual retirement account (IRA)?

Most municipal bonds (munis) pay interest that’s tax-free at the federal level (and sometimes at the state level). Therefore, they offer slightly lower yields than other, taxable bonds. Putting them in an individual retirement account (IRA) or a 401(k) does not typically provide an additional tax benefit, so there’s little incentive to pack these accounts with bonds that yield less.

How do you calculate the tax-equivalent yield for a municipal bond?

To calculate what the tax-equivalent yield would be on a municipal bond, you use the following formula: municipal bond yield ÷ (1 − marginal tax rate).

Because people have different marginal rates, the tax-equivalent yield will be different from one person to the next. The formula is a useful way to determine whether the tax benefits of a muni make up for its lower yield compared with taxable bonds.

Are all munis tax free?

No. For interest payments to be exempt from federal income tax, a bond needs to meet certain Internal Revenue Service (IRS) criteria. Bonds that don’t provide a significant benefit to the public typically don’t meet that standard, so they’re taxable. A third type of muni, known as a private activity bond, is exempt from income tax but subject to alternative minimum tax (AMT) calculations.

The Bottom Line

Municipal bonds (munis) can be a smart investment choice, especially if you’re in a higher tax bracket. However, in most cases, you’ll want to put tax-free munis in a taxable account, as IRAs and 401(k)s won’t provide an added benefit.

Read the original article on Investopedia.