Muni Bonds

[Matt]

Muni Bonds are provided by your 'municipality'. If you invest in them they have special tax status:

Up to Triple Tax Free for same state residents, EG New Yorkers:

• NY Residents who invest in NY Muni Bonds will receive income free of City, State, and Federal tax.

Note this is a general rule, there are some bonds that are considered Munis that will be taxed up to the Federal Level, this relates to certain Private Activity Bonds (though if the City needs the private activity, they will likely be tax free). Also, other bonds, such as Build America Bonds are taxable yet come with certain credits.

Other considerations

AMT
Some bonds will be subject to the Alternative Minimum Tax, you can generally assess this by asking your broker, and certain funds will have this in the title, such as iShares AMT Free Muni.

De minimis Taxation
Buying at a certain level of discount from Par (par is generally $1000 or $10000) may create De minimis tax, this applies to bonds selling at a discount 0.25% or greater, this creates capital gain taxation

Cap Gains
If you sell a muni bond for a gain it is taxed as a capital gain.. .only the income from the premiums is considered tax free, not the sale of the bond.

Impact on MAGI
Just like the AMT issue, income from Muni bonds is priced back into AGI to create MAGI (Modified Adjusted Gross Income) this rate is used to consider if your Social Security payments will be taxable, and if you are required to pay an increased amount for Medicare.

Investment Use
Munis should NEVER occur in a tax advantaged account (401k, IRA, etc) are best used for people in higher tax brackets. In order to compare the value of a Muni vs a Corp bond you need to run a quick calculation:

• Muni Rate /(1-tax rate)

Example: Bobby is in the 20% federal, 4% state and 3% city bracket, and wants some income from Bonds. He can choose a tax free option (3% Muni) or a corporate bond that is fully taxed (5% AAA bond). Which is better?

3%/ (1 - 0.2-0.04-0.03)
3%/ (1-.27)
3%/.63
Effective rate = 4.76%

Bobby would be better with the 5% taxable bond.

Example 2: Susan is in a 39.6% federal, 7% state, 6% city bracket and has the same choice of bonds

3%/(1-0.396-0.07-0.06)
3%/(1-0.526)
3%/.474
Effective rate = 6.33

Susan would be better with the 3% Muni bond.

Conclusion
Although the example above indicates a preference for the 3% muni for high tax payers, we must also remember the concerns regarding AMT.
The biggest problem you will likely face with Muni bond investments is making the mistake of stashing them inside an already tax advantaged account, if you plan to hold Munis and non-Munis remember:

• Munis ALWAYS go in Taxable
• Non Munis can go in either.

 

[Mountain Trader]

Great summary, Matt.

We used to buy munis, then our tax bracket evaporated when we retired. I plan to re-learn the market in a year or so as events are turning our bracket up a lot.

One elephant in the room are the unfunded pensions out thrre. When that tail snaps, it may break the bank for more than a couple of government entities and I want no part of that, at least in a game with an upside of a hundred basis points of yield.

 

[PaulNYC]

You need to be careful about credit risk with munis just as you do other bonds. Historically they've been a safer investment than comparably rated corporates. However, we have seen several bankruptcies with low recoveries in the "unlimited general obligation bonds" world ("full faith and credit" of the municipality) recently. This will likely continue when Puerto Rico restructures (PR is in many state specific funds because it's triple -- federal, state and local -- tax exempt), likewise the spread on Chicago, IL, NJ and a few other names have widened out recently causing the price of the bonds to fall. They may be "money good" (pay timely principal and interest) but if you need to sell a bond that has widen out due to unforeseen circumstances you may take a loss.

For most people they should still to municipal bond funds that have low fees. If you insist on buying your own bonds stick to unlimited general obligation bonds of high quality states. If your state happens to not be high quality (NJ, IL, etc) then it's not worth the credit risk since you don't really understand what you're buying. For example, the State of IL has a pension shortfall of around $100B (yes that's billion), the IL Constitution says that the state can not modify pensions and this was recently affirmed by the IL supreme court. IL's finances are in bad enough shape that they haven't been paying various vendors on time. If push comes to shove pensioners and the operations of the State will get funded and bond holders will take a hair cut. I think this is still a relatively low probability but you should at the very least be diversified in what you buy which is why a high quality mutual fund is best for most people.