When should you add tax free munis to a portfolio

[nun]

I'm not a particularly sophisticated investor so I've always wondered what place tax free muni bonds like VMATX have in a portfolio. Are they only appropriate for folks who have large retirement incomes that would put them in a high tax bracket or would they work for people in the $50k annual income range too?

 

[outofratrace]

This fund would give you a tax equivalent yield of 4.325% - 5.13% based on you being married filing jointly in the 15% tax bracket Income of (16,700-67,900 for 2009) with state taxes of 5.3 %. The range is based on SEC yield and distribution yield on the fund. Since it is a 9.5 year average maturity you have to be willing to hold for 9.5 years to get your principal back. While you can sell the fund anytime you still own maturities of 9.5 years. Generally I use munis to get me down to the 25% bracket then stop. I am not familiar with Massachusetts taxes but it looks like you are paying around 5.3%. If the yield is enough for you to take the slightly increased risk of Massachusetts munis over say a 5 year bank cd then you could put some money there.

 

[kaneohe]

Since it is a 9.5 year average maturity you have to be willing to hold for 9.5 years to get your principal back. .

What I've read is that you need to hold individual munis to be assured of
getting principal back. No such guarantee w/ a fund.

 

[Poundkey]

Someone here gave a good formula for deciding if Muni's were appropriate verses taxable.

Use this formula: Current yield ÷ (100 – your federal income tax rate)

Fund - yield
Inter-Term Tax-Exempt Inv - 3.45%
Total Bond Mkt Index Inv - 4.48%


Marginal tax rate = 28%

The equivalent yield of Inter-Term Tax-Exempt: 3.45 divided by (100-28) = 4.79% which is higher than that the yield of Total Bond Market fund.

 

[nun]

Generally I use munis to get me down to the 25% bracket then stop.

Can you explain this statement. Thanks

 

[Gotadimple]

Generally, all income is free of federal tax. So, perhaps a portion of this poster's funds are in muni's to limit his total income to the 25% tax bracket.

-- Rita

 

[LOL!]

Tax-exempt munis probably do not belong in most people's portfolios.

First, if one has any equities in tax-advantaged accounts, they can be sold to make room for more fixed income investments. That is, all your tax-advantaged accounts would need to be completely filled with fixed income so that you have no more room for fixed income in tax-sheltered accounts and needed to put fixed income in taxable accounts.

Second, one needs to look at the after-tax return of tax-exempt fixed income investments versus the after-tax return of regular fixed income investments. You want to get the higher return after taxes are paid. Since tax-exempt munis pay lower interest rates than taxable bonds, one would generally need to be in a high marginal income tax bracket above 28% to make this worthwhile. But do the calculation for your situation. In the 25% tax bracket, you generally make/keep more money by using regular fixed income and paying the taxes.

Third, note that tax-exempt interest is included in your income when determining how much of your social security benefits are taxed.

 

[ERD50]

Someone here gave a good formula for deciding if Muni's were appropriate verses taxable.

Use this formula: Current yield ÷ (100 – your federal income tax rate)

Fund - yield
Inter-Term Tax-Exempt Inv - 3.45%
Total Bond Mkt Index Inv - 4.48%


Marginal tax rate = 28%

The equivalent yield of Inter-Term Tax-Exempt: 3.45 divided by (100-28) = 4.79% which is higher than that the yield of Total Bond Market fund.

The math looks good, the trouble is trying to determine what your marginal tax rate (and how far down it goes). If you hold a lot of munis, some of it may dip below the marginal rate into the next lowest.

Last year, they didn't determine what the AMT limits would be until October of that tax year.

-ERD50

 

[Poundkey]

The math looks good, the trouble is trying to determine what your marginal tax rate (and how far down it goes). If you hold a lot of munis, some of it may dip below the marginal rate into the next lowest.

Last year, they didn't determine what the AMT limits would be until October of that tax year.

-ERD50

Good point ERD. I don't recall who posted the formula, but thought it might be a handy piece of info someday.

 

[outofratrace]

To retire really early you can throw tax-advantaged accounts out the window. I ER'd at 35 and I'm now 40. I use muni's to get rid of AMT on my taxes and get my taxable income down to the 25% bracket. The Vangaurd munis have been a good yield this year IMO. To really ER (before 50) you need to pour cash into taxable accounts. And I love them because I decide how much I can withdraw and not the govt.

Tax-exempt munis probably do not belong in most people's portfolios.

First, if one has any equities in tax-advantaged accounts, they can be sold to make room for more fixed income investments. That is, all your tax-advantaged accounts would need to be completely filled with fixed income so that you have no more room for fixed income in tax-sheltered accounts and needed to put fixed income in taxable accounts.

Second, one needs to look at the after-tax return of tax-exempt fixed income investments versus the after-tax return of regular fixed income investments. You want to get the higher return after taxes are paid. Since tax-exempt munis pay lower interest rates than taxable bonds, one would generally need to be in a high marginal income tax bracket above 28% to make this worthwhile. But do the calculation for your situation. In the 25% tax bracket, you generally make/keep more money by using regular fixed income and paying the taxes.

Third, note that tax-exempt interest is included in your income when determining how much of your social security benefits are taxed.

 

[LOL!]

I am happy that someone wants to pay lots more in taxes than they need to. Why settle for the 25% tax bracket? Why not the 0% tax bracket?

I love to have equities in taxable accounts and not cash. I keep my fixed income in my tax-sheltered accounts. The reasons have been explained many times on this and other forums.

 

[outofratrace]

It would be impossible for me to be in the 0% tax bracket unless I went to 96% equities as my tax-advantaged is only 4% of my portfolio and they were maxed out during my working years. I would be lucky to retire at 65 if I relied on just tax-sheltered. Nothing wrong with tax-sheltered accounts (especially Roth) but the earlier you want to retire the less important they are.

I am happy that someone wants to pay lots more in taxes than they need to. Why settle for the 25% tax bracket? Why not the 0% tax bracket?

I love to have equities in taxable accounts and not cash. I keep my fixed income in my tax-sheltered accounts. The reasons have been explained many times on this and other forums.

 

[Rambler]

LOL! has pointed out some good advice on this and other threads. For me, since my ability to use tax-favored accounts (401ks/IRAs) is not currently possible, and since my combined Fed and California marginal rate is 44.6%, munis make a lot of sense for me. The bond part of my port is yielding 5.6% of face value and around 5.9% of purchase price. These are all long bonds with coupons, and I am in for the long haul. So, at face value, the taxable bond equivalent yield is about 10.1% for me. I haven't seen any 10.1% corporates out there for a while that I would be comfortable buying.

All of this said, I am still working. As I come down the stretch to FIRE, some of my bond investments will go into corporates, so long as the yield is attractive and the rating is at least A or AA.

What I have now works for me, but it might not work for you, and really, do go back and read LOL!'s posts on the other recent thread about bond investing.

R

 

[LOL!]

To retire really early you can throw tax-advantaged accounts out the window. I ER'd at 35 and I'm now 40. I use muni's to get rid of AMT on my taxes and get my taxable income down to the 25% bracket. The Vangaurd munis have been a good yield this year IMO. To really ER (before 50) you need to pour cash into taxable accounts. And I love them because I decide how much I can withdraw and not the govt.

Yep, I agree that, in general, tax-advantaged accounts alone are not going to get you to early retirement because the annual contribution limits will restrict how much you have in them. If you are self-employed and putting in the $45K or so a year that helps, but may not get you there either.

Nothing wrong with muni's. Many folks need them. But don't be like my mother-in-law who hated to pay taxes. Her income was so low that she was in the 0% tax bracket. She still had munis. She could've had more money with taxable bonds.

And I wouldn't through my tax-sheltered accounts out the window. There's good money in there.

Just try to make sure your tax-sheltered accounts are filled up with fixed income before using muni's in taxable.

 

[nun]

I love to have equities in taxable accounts and not cash. I keep my fixed income in my tax-sheltered accounts. The reasons have been explained many times on this and other forums.

I hope to ER at 52 and was planning to set up a mix of a 4 year CD ladder and equities to get me to 59.5. Would you then suggest converting my after tax accounts to equities and setting up the CD ladder and all my fixed income investments in my tax deferred accounts?

 

[LOL!]

I hope to ER at 52 and was planning to set up a mix of a 4 year CD ladder and equities to get me to 59.5. Would you then suggest converting my after tax accounts to equities and setting up the CD ladder and all my fixed income investments in my tax deferred accounts?

Yes, but read this:

http://www.early-retirement.org/forums/f28/fire-and-tax-advantaged-accounts-45276.html

 

[nun]

Yes, but read this:

http://www.early-retirement.org/forums/f28/fire-and-tax-advantaged-accounts-45276.html

Thanks that's informative. I'm 4 years out from ER and 50/50 in my total portfolio, but 70/30 in my after tax investments so it looks like by pure chance I'm weighted towards tax efficient index equity funds in my after tax.

Like you my ER age goal is 52, but I think I'll keep at least a couple of years expenses in cash and the rest in vanguard equity index funds. I like the concept that whatever the market you can sell the equity fund in after tax accounts and repurchase something similar in a tax advantaged
account.

I'm going to forget about munis

 

[freebird5825]

I use TE muni bond funds for a totally different purpose. My post FIRE income has me in a much lower tax bracket, and I use them to keep it that way. I am nowhere near the AMT tax brackets, so that is not an issue. I do not collect SS benefits.
I face high property taxes, and predict they will just get worse as my state struggles with their budget. Right now I can afford the taxes out of my immediate income. I can see that changing in the not so distant future.
So instead of using traditional cash investments, I let my state pay me TE dividends on their muni bond issues through VNYTX, which in turn could be used to pay my school and county taxes. Likewise, I would use VWAHX to allow national munis to do the same.
My less than 5 year money for "just in case" situations is deposited through DCA, and I have the DCA amount set to essentially get a "match" in dividends every 30 days. This is an accumulation strategy for what-ifs. I do not use them as a long term income generator.

 

[clifp]

I had CA muni while working when it made a lot of sense to own them. I still own some mostly due to inertia and recently bought some when the muni market tanked due to issues with Muni bond insurers. I think 25% tax bracket is roughly the cut of level if you are above 25% marginally bracket you should probably own some, below that level you shouldn't and at 25% not much difference.

One word of advice, if you do buy individual issue ignore the insurance unless the insurance company is Buffett's company Berkshire Hathaway.

Historically Muni's have had far lower default rate corporate bonds of a similar rate. IIRC an A rated Muni has roughly the same chance of defaulted over a lifetime as a AAA corporate bond. So on a risk adjusted basis I think muni's have been a better deal. Of course the California crisis may soon render all of that data useless.

 

[PrivateCitizen]

Some additional muni tidbits

1) Note that most munis purchased purchased in your state are free of state and local income taxes, i.e. triple tax-free, so if if you think about it, the tax equivalent yield (TEY) formula understates the TEY.

2) Avoid FMSBbonds.com as they tend to mark up their prices on the high side. I prefer using ZionsDirect.com as price markups are more competitive and commission rate is $10.95 per trade. I always plug Zions, for both their competitive money market rates (1.39% last I checked) on internet accounts, and their low cost brokerage. Customer service, IMO, is among the best, and they tend to run a conservative/safe operation...even before the financial crisis hit. Have used them for about 4 years now.

3) General obligation bonds are safest, but revenue bonds whose revenue comes from relatively reliable sources such as turnpike road tolls, sewer usesage fees, and excise taxes such as that on cigarette are also sensible choices and yield a bit more.

4) Make sure you understand if the bond you're interested in has call and sink schedules. Besides the TEY, also check the yield to worst (YTW). If the bond has neither a call nor sink schedule, then the YTW == TEY.

5) Have invested in munis for about 4 years now, accumulating relatively safe triiple tax-free bonds over time, and carrying TEY's which I cannot obtain in the corporate or government bond markets.

that's it for now...