Create Tax Free Income for Life with Municipal Bonds
Now that you’ve read the somewhat salacious title of this article, the real question becomes “is there any truth to it”? A second question might be similarly, “what’s the catch”? Well, I hate to disappoint you but there is no catch and it is possible to create a tax free income stream for life. But how? It is done with an asset that has been around for literally ages—bonds.
In particular, this strategy can be executed successfully by using tax-free, non-AMT municipal bonds (what is a AMT bond?). Most investors shy away from bonds because they yield (or return) less than equities and tend to be more complex in nature. However, the global bond market is larger than the global equity market by $30 Trillion (see here) although the portion we will discuss in this article is much smaller at just shy of $4 trillion. So, why might you want to invest in municipal bonds to create tax free income for life?
What Are Municipal Bonds
First, municipal bonds represent an “I.O.U” issued by a governmental entity—usually state or local. They get their “tax-free” status because the money raised by the bond issue is usually for a “public good or service” like schools or roads. Money raised for these type of bonds are labeled as “general obligation” bonds and are backed by the full, faith and credit of the issuing entity’s taxing power. Generally speaking, the more taxing power, the better the backing. The idea behind tax-free interest from the bondholder comes from the fact that many schools and roads are usually funded by a large portion of taxpayer dollars. Thus, tax-exempt interest was born to incentivize the public to keep paying their taxes to fund projects. Ok, seems like a good deal, so why not use bonds in 100% of your investment portfolio?
There’s Still No Free Lunch
Well, like it’s been said before “there is no free lunch” and it is no different for municipal bonds. The rules of asset diversification apply even in the compelling case of tax-free income. Bonds have historically had little correlation to equities except in market crises situations, so creating a portfolio of both equities and bonds makes a whole lot of sense as a long-term investor. But when considering other fixed income vehicles like annuities or real estate which both generate taxable portfolio interest, individual municipal bonds make a good alternative. Take the case with your typical annuity (fixed or variable) that carries an average 2-3% annual expense charge when you consider: administrative, mortality and expense, mutual fund costs. And although you may not see it, don’t forget there will be a commission paid to the broker that sold you the annuity. So first year charges, can easily exceed 8%. Finally, you still have to pay taxes on the annuity income stream on all gains beyond your cost basis. Alternatively, you can invest the same amount into a diversified municipal bond portfolio and pay no taxes and receive tax free income until the bonds are called or mature. As an added bonus, your estate will receive a “step-up” in basis at your date of death greatly reducing any potential capital gains.
Why Not Use a Bond Fund?
This is a good question, and the short answer is that individual bonds are actually cheaper and a much more effective way of achieving “tax-free income”. Similar to annuities (mentioned above), bond funds have both explicit and implicit expenses. The explicit expenses like marketing, administrative, sales loads, etc. show up in the annual expense ratio. Granted, you can find a really low-cost index fund, but like actively managed funds, they have implicit costs which are not in the annual expense ratio. For example, what happens when the fund manager receives new capital in the fund and is compelled to buy bonds in an expensive market, or alternatively faced with selling bonds into a cheap market. This is referred to as liquidity premium (the former) or discount (the latter). There is also “cash-drag” where the fund manager may hold extra cash just to satisfy “potential” fund redemptions. Being a former portfolio manager myself, I realize not all bond fund managers effectively navigate these risks which translate in lower returns to fund investors.
“Buy and Hold”
Not the sexiest, but the “buy and hold” strategy for individual municipal bonds is by far the smartest. Here’s a brief example of the power of compounding in this article. Not only do you save the costs and expenses mentioned above, you also greatly reduce many of the risks that run off several other investors thereby creating a golden opportunity for the patient and savvy investor.
Check out these resources:
- “All You Ever Wanted to Know About Municipal Bonds”
- The Bond Book by Annette Thau
- Managed Municipal Strategy by DJH Capital Management, LLC.
P.S. I apologize for the infrequency of written posts to my readers. I’ve used the extra time to work on a book that I hope to have finished later this year. Until then, enjoy the podcasts and these sporadicly written posts!