Do you know the municipal bond definition? Many who are trying to set themselves up for a tax-free retirement have this unusual fixation with municipal bonds. However, today we’re going to discuss why you might want to think twice before investing in municipal bonds.
Those who have either purchased or contemplated purchasing a municipal bond have done so for two main reasons. First, they are exempt from federal taxes and relatively low-risk investments.
What Are Municipal Bonds? A Definition
The Municipal bond definition (or “munis” for short) is a debt security issued by states, cities, counties, and other governmental entities. The purpose of munis is to fund day-to-day obligations and to finance capital projects such as building schools, highways, or sewer systems.
By purchasing municipal bonds, you are, in effect, lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or “principal.”
A municipal bond’s maturity date, or the date when the issuer of the bond repays the principal, may be years down the road. Short-term bonds mature in one to three years, whereas long-term bonds take more than a decade to mature.
Why Do People Consider Purchasing Municipal Bonds?
Well, the terms tax-free and low-risk seem like the alignment of the stars when it comes to tax for retirement; I would caution you to think twice before taking the plunge.
There are some reasons why I would be extremely cautious about making municipal bonds part of your tax-free retirement strategy.
6 Reasons to Be Extremely Cautious
Now that you know the municipal bond definition, you need to be cautious. Sure, being tax-free sounds awesome, right? But do you think the government is going to let you get away with tax-free? Here are six reasons you need to be cautious about using municipal bonds to go tax-free.
Provisional Income
First, when learning about the municipal bond definition, learn that interest from a municipal bond counts as provisional income. That means it counts against the thresholds that cause Social Security taxation.
So, while you may be looking for a stable, predictable tax-free stream of income, you could unknowingly lose a portion of your Social Security along the way.
Remember, if, as a single person, your provisional income is greater than $34,000, or if you’re a married couple with a provisional income that’s greater than $44,000, up to 85% of your Social Security could become taxable to you at your highest marginal tax bracket.
That can cause you to lose up to a quarter of your Social Security, forcing you to spend down all of your other assets 5 to 7 years faster than those who receive their Social Security tax-free.
Tax Rate Risk
Second, municipal bonds are not always entirely tax-free. Even though they are free from federal tax, they are often taxed at the state level. Currently, 43 of the 50 states charge state tax on out-of-state municipal bond interest.
So, as state taxes rise over time to keep pace with states’ unfunded obligations, you could unwittingly fall prey to tax rate risk.
Inferior Rates Of Return
Third, and if not most important, municipal bonds offer inferior rates of return. The problem is that even though municipal bonds are tax-free, they offer returns far less than their taxable corporate bond equivalent.
Even the best municipal bonds might only get you 2 1/2%, and while it’s a tax-free 2 1/2%, it’s still only 2 1/2%.
So the question you have to ask yourself is this: What are you accomplishing by achieving a 2 1/2% tax-free rate over time? The answer is: not much.
In fact, if the inflation we’re experiencing keeps up, you’re actually losing spending power by locking into even the most productive Municipal bonds. I’ll pass, thanks.
Purchasing Power Risk
This highlights one of the biggest problems with municipal bonds, and that’s purchasing power risk. That’s the risk that your returns will lag inflation and reduce your spending power over time.
Interest Rate Risk
Municipal bonds have interest rate risk. The longer the term of the bond, the greater the risk. If interest rates rise during your bond term, you’re losing out on a better rate. Likewise, you could even risk losing your principal investment when interest rates fall.
A bondholder selling a 30-year issue may receive less than the bond’s initial cost. So there’s really no guarantee that you won’t lose the principal in the long run. Keep that in mind as you learn the municipal bond definition.
Call Risk
Municipal bonds have call risk. A municipal bond that’s issued with a callable option means that the municipal issuing the bond can cancel the issue, pay off the principal, and stop interest payments.
The Issuer will typically go this route to hedge against falling interest rates. If interest rates were to fall substantially, they could issue a new bond at a lower interest rate.
Here’s the deal: Almost every municipal bond is callable. That means if interest rates drop and your municipal bond is called, you will have to find another place to put that money.
What to Consider Instead of Municipal Bonds
So if municipal bonds are out, how can you get consistent, predictable tax-free income at retirement? Here’s an idea: Why not own an annuity inside a Roth IRA?
Before you get too worked up over the word annuity, think about it this way. If you don’t like annuities, you almost certainly won’t like Social Security or that pension plan you’re planning on receiving. Why? Because they all work according to the same principles as an annuity.
Advantages of an Annuity Inside a Roth IRA
Higher Rates of Return With Lower Risk
There are some advantages of owning an annuity within a Roth IRA. If you were to reach into any stock-bond portfolio and replace a bond portion with an annuity, you could instantly increase the rate of return, lower the risk, and reduce the standard deviation.
Remember, annuity companies have massive economies of scale. Hence, they can get rates of return in their bond portfolio that far exceed what you can get on your own. So, they’re giving you greater returns without all the risk.
You Can Own That Annuity Inside A Roth IRA
Second, you can actually own that annuity inside a Roth IRA. Now you might have to start with an annuity inside your IRA. But if you do a piecemeal internal Roth conversion, you can systematically convert an annuity IRA to a Roth IRA, taking advantage of historically low tax rates along the way.
So not only can you experience high rates of return, but you can do so in a tax-free environment. That means they are less likely to succumb to purchasing power risk over time.
Distributions From Roth Annuities Don’t Count As Provisional Income
A distribution from any Roth account, including annuities within those Roth accounts, doesn’t count as provisional income. It doesn’t count against the threshold that causes Social Security taxation.
It dramatically increases the likelihood that you could receive your Social Security 100% tax-free!
As a result, you won’t have to spend on all your other assets to compensate for that Social Security taxation, so your portfolio lasts longer.
Guaranteed Tax-Free Income For Life
For trying to protect yourself against longevity risk, the Roth IRA annuity can provide guaranteed tax-free income for life.
Final Thoughts: Municipal Bond Definition
Now you know the municipal bond definition. If you’re looking for a safe investment option, municipal bonds are rarely the best option. You will potentially expose yourself to Social Security taxation, state tax some of the time, purchasing power risk, interest rate risk, and call risk.
With a bit of proper planning, you won’t ever have to rely upon municipal bonds with all their inherent defects. Think about it this way: if you’re taking advantage of all the tax-free nooks and crannies the IRS affords you, you can shield yourself against taxes and utilize financial instruments that won’t expose you to the shortfalls of municipal bonds.
You’re much better off simply replacing the bond portion of your IRA portfolio with an annuity and then converting it systematically to a Roth IRA.
These accounts are a hundred percent tax-free, will increase the likelihood you get your Social Security tax-free, offer superior returns over time, and can guarantee that you’ll never run out of money.
Frequently Asked Questions
A simple municipal bond definition is an investor loaning money to a government to help build and repair their infrastructure.
The rising interest rates are a big downside to municipal bonds.
Tax-free income made from interest is the biggest advantage.
The consistent tax-free income is one of the biggest reasons wealthy people like to buy bonds.
