When you reach retirement age, one of the most common ways to generate passive income to supplement your other sources of cash, such as a check from a pension or Social Security, is to invest your savings in tax-free municipal bonds. This is one of the most popular ways to generate income in retirement. This portfolio strategy has the potential to offer a number of significant benefits.
The interest received from municipal bonds is exempt from income taxation at both the federal and state levels.
Imagine that you have reached the age of 65. You have worked hard over the course of your life and have amassed savings of $500,000, have no outstanding debt, and own your home free and clear. You have the option of purchasing bonds issued by general corporations or bonds issued by municipalities that are exempt from taxation. The return on investment for the corporate bonds is 7%, while the return on investment for the tax-free municipal bonds is 5%. That means the corporate bonds would produce an annual interest income of $35,000 for you, which you could use to maintain your standard of living, pay your bills, stock your pantry with food, and keep your medicine cabinet stocked. If you wanted to keep this money, you would have to file and pay regular income taxes on it. On the other hand, the interest income from the municipal bonds that are exempt from taxation would amount to $25,000 annually. If you bought bonds that were issued in the state where you live, you wouldn't have to pay any federal or state taxes on the interest you earned from these bonds. Which of these two would be a better addition to your portfolio as an investment option? Calculating something that is known as the taxable-equivalent yield is what you need to do in order to find the answer to that question. As a general rule, the lower your tax bracket, the more advantageous it is to invest in corporate bonds; conversely, the higher your tax bracket, the more advantageous it is to invest in municipal bonds. One pitfall that you should steer clear of is the practice that many new investors seem to pick up, which is the habit of putting tax-free municipal bonds in retirement plans that are shielded from taxes due to the inherent structure of the plan. This is a mistake that you should try to avoid making. Even if you are in the highest tax bracket that is levied in the United States, the income that is contained within your 401(k) plan or other retirement accounts is already shielded from the IRS. This fact makes the yields on corporate bonds a better choice from the perspective of taxation in the majority of circumstances. Remember the rule that opposites attract, which states that taxable bonds go into tax-free accounts and tax-free bonds go into taxable accounts. This is a useful rule to keep in mind.Municipal bonds are known to be subject to less volatility than stocks.
Your assets may experience greater or lesser volatility than stocks, according to the duration of the municipal bonds you have purchased for inclusion in your investment portfolio. In general, the price of a bond with a shorter duration (one that matures at an earlier date) will be subject to significantly less volatility than the price of a bond with a longer duration (one that matures many years in the future). The economic dictum that "everything comes with a price" is accurate. "You can't get something for nothing," as the saying goes. Bonds with a shorter duration almost always offer yields that are lower than those offered by bonds with a longer duration. That is the compromise that you will have to accept. There are infrequent instances once every few decades in which this is not the case. An "inverted yield curve" is the term used to describe this economic phenomenon.Emotionally, bonds may be appealing.
When you invest in municipal bonds on the primary market, the money you provide is loaned to a local or state government for the purpose of funding projects that improve the quality of life for the typical citizen. If you invest in bonds that are offered by a school district, it is likely that your money will be put toward the construction of a new school or gymnasium. If you invest in a municipal bond that is issued by the municipality where you live, the money you pay for it may be put toward the building of public works such as roads, bridges, hospitals, and sewage treatment plants. The issuer of the bond makes the promise to pay interest to the holder of the bond in each of these scenarios. You are promised that you will receive the return of the par value of the bond itself on the maturity date in the future at some point in the future. This is typically equivalent to the total amount of money that you initially loaned to the issuer, and it unquestionably is in the instance of a conventional tax-exempt municipal bond. Having the knowledge that you are going to get your money back at a specific point in the future as long as the bond issuer doesn't default makes holding tax-free municipal bonds easier psychologically and emotionally for many investors. This is because of the simple fact that you are going to get your money back. Even though they are aware that over the course of a longer period of time, stocks significantly outperform bonds in terms of return, there are some retired investors who are currently sitting on seven-figure portfolios that are filled with municipal bonds. These investors don't mind the fluctuations in price, but they can't stomach the idea of holding any stocks, regardless of how high-quality, profitable, or well-diversified the stocks may be. To put it another way, even though it might be irrational, many new investors believe that bonds are in some way inherently safer than stocks. They ignore things like the risk of an increasing rate of inflation. You are not required to invest in stocks in order to amass wealth, and you may find that devoting your savings to fixed-income investments such as tax-free municipal bonds will help you get a better night's rest.Questions That Are Typically Asked (FAQs)
How does one go about purchasing municipal bonds?
There are a few different ways to purchase municipal bonds; however, the methods that are most straightforward require the use of a brokerage account. Certain brokerages provide their clients with access to recently issued municipal bonds, which can be purchased directly from the issuing entity. On the secondary market, you might have the opportunity to purchase individual bonds from other traders. There are also exchange-traded funds and mutual funds that invest in municipal bonds. These funds and ETFs automatically diversify their holdings across a large number of different municipal bonds. Some of these bond funds concentrate their efforts on a single state, giving investors the opportunity to tailor their holdings to the state in which they currently reside.What are the interest rates that are currently being offered on municipal bonds?
Using an index such as the S&P Municipal Bond Index is one way to get an idea of how the bond market as a whole is doing. You can get a general idea of the market's average by looking at the average yield to maturity of these kinds of indexes. From there, you can determine whether to anticipate a higher or lower yield, depending on factors such as the credit risk associated with the bonds and whether or not they are short-term or long-term.