Who Needs Munis?

Jonathan Clements

IT’S A COMMON PLOY among columnists: You start with the provocative statement—and then spend the rest of the article dancing like crazy, trying to defend it. Today’s provocative statement: Except in a few rare instances, I’m not sure why anybody would ever own municipal bonds.

At first blush, this sounds not just provocative, but downright stupid. If you’re in a high income-tax bracket and investing money through a regular taxable account, it would be foolish to buy taxable bonds and then pay income taxes on the interest you earn. You would be better off sidestepping that tax bill and instead purchasing lower-yielding but tax-free municipal bonds.

That’s correct, except for one small issue: Why would you buy bonds in a taxable account? Why not use your taxable account to pursue a tax-efficient stock strategy, such as investing in broad stock market index funds, so you take advantage of the special low rates on long-term capital gains and qualified dividends? Meanwhile, to the extent you want to own bonds, why not purchase taxable bonds in your retirement account and reap the benefit of the higher yield?

This suggestion would not be helpful for two groups of high-income investors. First, there might be folks who have little or no money in tax-favored retirement accounts, so there’s no way they could buy all the bonds that their portfolio requires in a retirement account. Second, there may be high-income earners who want nothing to do with the stock market, so their entire portfolio is in bonds. For these investors, I graciously concede that owning municipal bonds in their taxable account makes sense.

But not for anybody else.

“Wrong,” you cry. “I’m worried about a financial catastrophe, such as losing my job or a huge medical bill. That means I need easy access to cash—and the right strategy, at my lofty tax bracket, is to own munis in my taxable account.”

Maybe not. Imagine you have $100,000 in stock-index funds in your taxable account and $100,000 in taxable bonds held in your retirement account. Your world then implodes. Not only do you lose your job, but also the stock market plunges 30%.

Now, you have $70,000 in stocks in your taxable account, which you are loath to sell at such depressed prices. Meanwhile, your bonds have rallied to $105,000, but you can’t get access to that money without paying tax penalties, because it’s sitting in a retirement account and you’re under age 59½.

Game over? Not at all. Let’s say you need $20,000 to cover your living expenses for the months ahead. You cash in part of your stock-index fund holdings, perhaps realizing a tax loss in the process. Even with a tax loss, that doesn’t seem so smart, because you just sold stocks at fire-sale prices.

But the damage is easily repaired. Within your retirement account, you shift $20,000 from bonds to stocks. Result: You still have the same amount in stocks. Indeed, you have effectively sold bonds to cover your financial emergency.

And, no, this isn’t some crazy pie-in-the-sky strategy: It’s how I handle my own portfolio—with my taxable account entirely in stock-index funds and all my bonds held in my retirement account.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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