Turns out, the taxman has a gift for you.
There are better returns to be found than your typical blue chip dividend stock, or US government treasuries.
If you are looking for a safe and stable stream of tax free income, this is something you should know about.
There is a great Forbes article outlining why municipal bonds, while boring, can be a great option for investors.
From the article:
“Municipal bonds’ income gets a big boost from a surprising source: the IRS. That’s because the income they hand you is almost always federal-tax free and, in most cases, free of state taxes, too.
The effect? Dramatic.
Let’s imagine a muni bond yielding 5%. If you’re in the 28% federal tax bracket, you’d need a 6.94% yield on corporate bonds or dividend stocks to get the same after-tax income our muni bond pays.”
And the effective return only rises in higher tax brackets. As we’ve discussed previously, a roughly 7% return from the stock market is no guarantee. It’s also important to remember that this is not including any state level tax exemptions.
Risks of municipal bonds
The only real risk with investing in municipal bonds is the inverse relationship between interest rates and bond values. In an environment of rising rates like today, where the Fed has raised rates 7 times in the last 3 years, this can be a big concern for investors.
While interest rates can have a depressing effect on the performance of bonds, the appeal lies in the steady and reliable income. Again from the Forbes article:
“While some munis are backed by the full faith and credit of the government, some are “revenue-backed,” which means they’re tied to the success of the project they’re funding.
But you shouldn’t lay awake at night worrying about these funds, because municipal bond default rates have been below 0.03% over the last decade!”
This is great news for investors looking for safety and security, whether due to risk aversion or retirement horizon.
Income from municipal bonds
But what intrigues me the most about municipal bonds is the effect at much larger investment amounts. This is where the magic happens.
MJ Demarco, author of The Millionaire Fastlane and Unscripted, is a big fan of municipal bonds for this very reason. From Unscripted:
“For example, take a paltry 3.5 percent return, which is offered on a municipal bond. The effective return, because it’s exempt from taxes, is nearly 7 percent. Take a look at the difference in monthly, passive returns.
- $1,000 investment = $2.91 per month
- $4 million investment = $11,666.66 per month
More than $10,000 per month, tax-free, doing absolutely nothing, and with a tiny interest rate. Imagine the joy. Imagine the freedom.”
(See: it takes money to make money)
The first thing to notice is that his “nearly 7 percent” effective return comes from a stated 3.5% return, which tells us that unlike the first example of an investor in the 28% tax bracket, Demarco’s marginal tax rate is much higher, so the tax advantage is even greater.
Secondly, Demarco could go even further with the feel-good-ness by pointing out that the 5-figure passive income generated in the above example is without touching the principal.
The holy grail of financial freedom
This is the dream, isn’t it? Your money is literally earning it’s own money, and in amounts large enough to cover all your living expenses. For anyone interested in financial independence, this is exactly what it looks like.
Keep in mind, if you are only investing $1,000 in this way (or only have $1,000 to invest, period), you may not have the level of income that really benefits from the strategy in the first place. You are probably better off participating in equity markets in the early going, or if you still have multiple decades until retirement, until you are well into a 6 figure nest egg.
There is also a synergistic effect between income and expenses by the time most people are in a position to take advantage of this strategy.
For example, by the time I am in position to invest heavily in fixed income securities, I will be finished with the most expensive time of my life. I will no longer be spending on daycare, paying down student loans, or (fingers crossed) have a mortgage payment. These are easily my 3 biggest expenses, combining to cost me over $2,000 every month.
By the time these are gone, I will be at less than half of my usual spending, which means my required income is halved as well.
Let’s say I want to utilize a municipal bond investment strategy. When I only need $2,000 per month, my total investment balance can be as low as $480,000 at 5% returns. And remember, this is tax free income, unlike a “4% safe withdrawal rate” strategy out of a brokerage account.
It’s a refreshing notion to think about needing less than half a million dollars to be financially free, without being vulnerable to market fluctuations.
Growth and Income potential
But for those with high marginal tax rates, or sizable investment balances, investing in municipal bonds can be ideal. In fact, if your balances are high enough and living expenses are low enough, you might have a significant gap between your investment earnings and expenses. This allows you to reinvest and grow your nest egg even further, perhaps for future generations or to otherwise leave a legacy.
Regardless of your age, income, or current level of assets, it’s clear that an investment strategy like this deserves consideration by every investor. Both the Forbes article and MJ Demarco’s Unscripted go on to discuss specific high performing bond funds to check out to get started.