Bonds of any sort, let alone municipal bonds are hardly an exciting investment option for younger adults and rarely receive any attention in the personal finance world. This is not unexpected since common knowledge tells us that the younger you are the less you should be invested in bonds or fixed income investments. So why worry about them, aren’t these things just for old people? Hardly, there are many scenarios where municipal bonds could play an important role in your portfolio.
First, how many of you like Roth IRAs because of the tax-free benefits? If I had to take a guess, I’d say virtually everyone loves tax free money. What happens when you max out your Roth contribution and you’re putting all you can into any employer or traditional IRA accounts? If you haven’t guessed it already, municipal bonds can fill the gap and provide even more tax-free growth. Obviously most of you are probably thinking, “yeah but bonds generally pay low interest, I’ll never be able to obtain the 10% or so average I see in my equity investments”. Well, yes and no. Bonds typically aren’t going to perform like equities, they aren’t supposed to. But many people underestimate the taxable equivalent yield on municipal bonds. (The higher your tax bracket or the higher income taxes are in general the greater the benefit)
Remember, municipal bonds are federally tax free and if you purchase a bond in the state you reside in, it is state tax free. Not only that, but if you purchase bond issued by the city or county you live in it may also be free from local taxes. To take a look at how the tax-equivalent yield works CNN Money has a nice little calculator you can try out. By default it puts 5% in there, which you can find on some bonds. As of now you are generally looking at anywhere between 3.5%-5.25% depending on issue. Next just enter your tax rates and calculate. If you are in the 25% tax bracket and your state has a 5% tax, that 5% yield bond is the equivalent of 7.14%. Well that is nothing to sneeze at, especially if you purchase an insured bond. Where else can you guarantee your principal and see that sort of return?
Again, these are for situations where you are unable to make additional Roth contributions or to other favorable tax accounts. Obviously you want to maximize these first. Once you run out of places to shelter money from taxes you don’t have to rely on taxable investments, which is where muni’s come in. Also note that investing in individual bonds is unlike buying a stock or mutual fund and you may need to do a little reading to get up to speed. Just like any investment, you want to be sure that you understand how they work before putting your hard-earned money into them. For those who may not like to be tied to a maturity date or care to buy individual bonds there are plenty of municipal bond mutual funds available that can assist you. Unfortunately you will generally not see the best yields and your principal invested can go down since the fund invests in a bunch of bonds just like an equity fund invests in many companies.
Of course for younger adults bonds should still be a relatively small part of your overall portfolio, but if you have run out of room for contributing to your other retirement accounts then this source of tax-free income can be a great supplement to your overall portfolio. Some will argue that they can just invest in taxable accounts and earn more after taxes and that’s fine. This is for a relatively conservative way to earn tax-free income that should earn more than liquid assets and a little less than equity investments. But if you’d rather take a stick in the eye that’s fine by me too.
For a list of some available bonds: Fidelity Municipal Bond Search
For some basic bond investing information: How Bonds Work
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
