If you’re grabbing tax-free income from this asset, you may be sacrificing yield

Published Fri, Jun 21 20242:55 PM EDT

Municipal bonds are enjoying a moment among investors who are looking for tax-free income, but they should be wary of allowing tax savings to drive their decisions. This week, Wells Fargo Investment Institute highlighted the attraction of muni bonds as the Federal Reserve prepares to trim rates. Bond prices rise as yields fall, and a falling rate environment would result in price appreciation for municipal bonds. "We remain favorable on municipal bonds, both essential revenue and general obligation bonds, as they have historically been resilient during periods of economic uncertainty," Wells Fargo noted in a report this week. "For investors in higher effective tax brackets, we believe municipal securities are an important part of fixed-income positioning." But that is where investors can make a misstep – one that may cost them valuable income opportunities. Though municipal bonds generally offer income that's free of federal income taxes – and state taxes if the investor resides in the issuing state – they also come with lower yields compared to other bonds. That's the trade-off investors make for the safety of general obligation bonds, which are backed by the full faith and credit of the issuing municipality. Even exchange traded funds holding municipals will have a lower 30-day SEC yield, compared to their corporate counterparts: The Vanguard Tax-Exempt Bond ETF (VTEB) has a 30-day SEC yield of 3.64%, while the Vanguard Total Corporate Bond ETF (VTC) has a 30-day yield of 4.17%. "Munis aren't always the best option," said Nisha Patel, senior portfolio manager at Parametric Portfolio Associates. "There are lower [tax] brackets, and the client might've been better off on an after-tax basis if they bought Treasurys and corporates." Indeed, earlier this year Parametric kicked off a service it offers to financial advisors, building tax-optimized bond ladders that are based on an investor's specific bracket. Knowing your bracket The general rule of thumb is that if your marginal tax rate is in the 24% bracket and above, you're a better candidate for a municipal bond. When it comes to muni bonds, the higher your tax bracket, the more valuable the tax-free income is. Consider that if a taxpayer in the 32% federal income tax bracket picks up a muni bond with a tax-free yield of 3%, she would need to find a taxable bond yielding 4.41% to generate a comparable level of income, according to New York Life Investments . That's called the tax-equivalent yield . Investors in lower tax brackets just might pick up more after-tax yield in the corporate space, considering that even though the interest from corporate bonds is taxed at the same rate as ordinary income, the levy may not take as big of a bite out of their returns. "The idea of not having to pay taxes sometimes blinds investors to the idea that you can still end up with more money if you invest elsewhere and pay taxes on that," said Collin Martin, fixed income strategist for the Schwab Center for Financial Research. "You may be able to get a higher after-tax yield with something like a corporate bond," he added. Treasurys are also another consideration for investors, as they offer interest income that is subject to federal tax, but exempt from state and local taxes. A tax-conscious approach to fixed income You don't have to bulk up on municipal bonds to get the best yield for your tax scenario. Here's where to begin. Think about your time horizon and your effective tax rate. You may be in a high tax bracket now, but whether it makes sense to load up on munis will depend on how that situation may evolve. "If they're paying taxes at the highest marginal rate, but plan to retire in three years – at which point they won't have wages – their marginal tax rate will drop," said Michael Carbone, certified financial planner and financial advisor at Eppolito Financial Strategies in Chelmsford, Massachusetts. In that case, the tax-equivalent yield on a muni may have seemed promising in those high-earning years, but it becomes much less attractive once earnings drop off. Consider where you're keeping these bonds. Save on taxes by ensuring that your bonds are in the correct accounts. Municipal bonds are good contenders in taxable brokerage accounts, where investors can benefit from their tax-free income. Corporates and the funds that hold them – especially given higher yields – might be better suited for tax-deferred accounts, such as your individual retirement account, given the tax treatment of their interest income. Shopping for tax-aware funds? Do your homework. Some fund families offer "tax-aware strategies" either in mutual funds or ETFs, which can include some exposure to municipal bonds, as well as equities. These options may help investors save on taxes, but they should understand what these portfolios hold and how much they cost. "As we spend more time understanding these tax-aware strategies that have popped up in the last five years, it's better to understand what is in the portfolios and where risks can surface," said Beth Foos, associate director of fixed income strategies at Morningstar. "Looking at the fees and understanding how they impact your results is really important."