Tax Free Municipal Bonds Or Taxable Bonds?

If you’ve been a diligent saver and maxed out your 401k at work and Roth IRA at home, congratulations! You’re well on your way to a comfortable retirement. But what if you still have money to invest? One of the more difficult questions to answer when it comes to taxable investing is whether you should reshuffle your tax-advantaged accounts to make more room for tax-inefficient bond funds or to go with tax free municipal bonds in a taxable account.

The Rule Of Thumb:

The rule of thumb is that bonds go in tax-deferred accounts and more tax-efficient equity funds should go in taxable accounts (assuming you don’t have enough room for both in your 401k). The reason for this is that taxable bonds have much higher yields than even the most generous high yield municipal bonds. That said, most investors will eventually hit a point where they simply don’t have enough room in their tax-deferred accounts for the quantity of bonds required to fill out their asset allocation. Part of this is due to the fact that the longer you invest, the larger your portfolio will naturally become. But most of it is due to the simple fact that as we grow older, we usually become more conservative and wish to allocate a larger percentage of our portfolio to bonds.

The Taxable-Equivalent Yield Formula:

So you have no choice but to own bonds in a taxable account. How do you decide which is better, tax free municipal bonds or taxable bonds? The formula is actually pretty simple. Note: If you buy municipal bonds from the state you live in (for example California if you live in California, etc), the interest earned on them is also exempt from state income tax, which you should factor into the formula below.

Taxable-Equivalent Yield = municipal bond interest rate / 1 – (federal tax rate)

If the taxable-equivalent yield of a particular muni bond fund is greater than the yield on a comparable taxable bond fund, you are better off owning municipal bonds. If it’s lower, you’re better off owning taxable bonds even after paying tax on the income.