They come with a world of tax benefits.
Stocks can be an extremely appropriate investment for long-term goals. When you’re in the process of saving for retirement, it pays to load up on stocks in your portfolio.
But once you enter retirement, it’s generally a good idea to go a little less heavy on stocks and move over to safer investments, like bonds. This doesn’t mean retirees should ditch stocks completely. Rather, it’s a good idea to not have them constitute too large a chunk of your portfolio.
The logic is that by the time you’re in retirement, you’re most likely in the process of taking withdrawals from your 401(k) plan, IRA, or whatever account you have. So you want some assets that are less prone to volatility than stocks, and bonds generally fit that bill. But if you’re going to hold bonds in retirement, there’s one type I’d recommend focusing on.
The upside of municipal bonds
Many people are used to putting their money into corporate bonds — those issued by corporations. But I think municipal bonds are a more suitable choice for retirees for a couple of reasons.
First, taxes can be a burden in retirement when you’re on more of a fixed income. And unfortunately, a lot of common senior income sources are subject to taxes, including withdrawals from a non-Roth retirement plan, dividend payments, and even in some cases, Social Security.
The great thing about municipal bonds is that the interest they pay is always tax-exempt at the federal level. And if you buy municipal bonds that are issued by your state of residence, you can avoid state and local taxes, too.
Keep in mind that this rule applies to municipal bond interest payments only. If you sell your bonds at a gain, you’ll be liable for capital gains taxes. But not having to pay taxes on your interest income is definitely a positive thing.
There’s another reason I’m a fan of municipal bonds as a retirement investment: They have a really low default rate, historically speaking. This makes them an investment seniors shouldn’t have to lose sleep over.
Vanguard reports that the cumulative default rate for investment-grade municipal bonds (meaning, non-junk bonds) is 0.09% per 10-year period. Across the corporate bond market, the default rate for that same time period is 2.17 — more than 20 times the default rate for municipal bonds.
A big reason municipal bonds have such a low default rate is that many of them are backed by the full faith and credit of the municipalities that issue them. That gives states, cities, and other localities the option to raise and move money to make good on their promises to bondholders.
Also, a lot of municipal bonds are backed by specific revenue streams. A city might issue municipal bonds to raise money to build a highway. The toll revenue collected from drivers could then be used to satisfy bond obligations.
Although I don’t own a lot of municipal bonds right now (largely because I’m trying to invest more aggressively while retirement is still decades away), I think they’d make a great investment down the line. If you’re on the cusp of ending your career, I’d recommend adding them to your portfolio.
