The case for Muni Bonds

Do municipal-bond funds make sense in retirement accounts?

Most retirement savings are sheltered in individual retirement accounts, 401(k)s and other tax-deferred vehicles, so many people don't think of munis when they think of saving for retirement.
After all, munis already are free from federal income tax, and often state and local income taxes as well. It wouldn't make sense to keep them in an IRA, where those advantages would be wasted.

But for the taxable portion of one's savings, muni-bond funds can be an attractive alternative to money-market funds and certificates of deposit.

High earners in particular can profit. In 2012, the yield on taxable money-market accounts was less than a percentage point, while the average tax-free yield on municipal-bond funds was 1.75%. That is the equivalent of a 2.7% taxable yield for someone in the 35% income-tax bracket.

Whether muni funds make sense depends on your income, your state, whether you are receiving Medicare and Social Security and your risk tolerance.

Let's start with risk. Many investors have avoided munis since late 2010 and early 2011, after dire predictions of mass defaults by municipalities and states led to panic selling. And there still is plenty of bad news, including a ruling by a federal judge earlier this month to allow the city of Stockton, Calif., to reduce its debt in bankruptcy.

But the default tsunami some predicted hasn't happened. Local governments trimmed budgets, laid off public employees, reduced services and raised taxes.

As credit risk improved, municipal bonds rallied. In the year ended March 31, investors have poured $42 billion into muni-bond funds, according to investment researcher Morningstar.

Meanwhile, amid continuing economic and political uncertainty, local governments have been reluctant to start capital projects, and this combination of increased demand from investors and tight supply due to fewer issues drove muni prices higher.

Tax-free interest must be included when determining the portion of Social Security benefits that is taxable and when calculating Medicare premiums. Couples with income of more than $170,000 ($85,000 for singles) pay a surcharge of $42 a month for Part B premiums. The surcharges rise with income and reach a maximum of $231 a month when income reaches $428,000 for couples ($214,000 for singles).

Some fear that Congress will cap the value of the tax exemption for munis, as the Obama administration has proposed doing to raise revenue. Yet prior attempts to rein in tax breaks on munis have failed.

Beginning in 2013, net investment income above $250,000 for couples ($200,000 for individuals) is subject to a new Medicare surcharge of 3.8%. However, income from muni bonds doesn't count as investment income when calculating the surtax.

That's another thing that makes munis look good right now.

Source:  Ellen Schultz, Wall Street Journal

D2 Capital Management's Tax Free Income Portfolio consists of a diversified mix of highly rated municipal bond mutual funds.  The Portfolio currently has a 1.83% SEC 30 day yield and a 3.24% trailing 12 month yield which results in a 4.5% tax equivalent yield for an investor in the 28% Federal Income Tax bracket.

The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.

 

The Jacksonville Business Journal has ranked D2 Capital Management in the top 25 of Certified Financial Planners in Jacksonville.  The Firm is also a member of the Financial Planning Association of Northeast Florida.