Often retirees will have excess funds sitting in the bank. Far more than they need for an emergency. And in some extreme cases, they have all their money in the bank because they don't feel comfortable putting it in stock-related portfolios.
The result is that they may spend their golden years struggling to have enough income to live a comfortable lifestyle.
One possible solution — especially for retirees in the middle tax brackets — is to consider higher-quality, shorter-term tax-free bond funds. This way, instead of renewing what are often one- or two-year CDs every year for the rest of their life, they may be able to get a much better after-tax income.
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How Risky Are Municipal Bonds?
Municipal bonds — or munis for short — provide a way that states or municipalities can borrow the funds they need to finance a public works project, and the interest they pay to investors who buy into them is exempt from federal taxes. Owners may owe a little in state taxes if the fund owns bonds issued outside their home state, but the same state income tax is always owed on the CD interest, so this would not eliminate the munis’ advantage over CDs.
The first thing to understand about tax-free municipal bonds is that unlike the money in the bank, they fluctuate and tend to move in the opposite direction of interest rates. Also, they are not FDIC insured.
How Can You Reduce That Risk?
However, there are strategies to reduce the overall risk enough so that some retirees may feel comfortable with them, and end up likely enjoying higher income. The way to reduce fluctuation in a municipal bond fund is to make sure that the average maturity of the bonds inside the fund is reasonably short. For example, Vanguard Intermediate Term Tax Exempt Fund Admiral (VWIUX) has an effective maturity of 5.3 years. Such short maturities tend to keep the fluctuation of the share price of the bond fund very modest most of the time.
To illustrate, if we go back the last 10 years this fund had one negative year, where it was down less than 1.5%. All the other years it had a positive return and a 10-year average annual total return of 3.88%. And, unlike with CDs, the interest it generated was tax free. Also, while the fund itself does not have a specific maturity date, the mutual fund shares are liquid, so the retiree can sell them on any business day at the fair market value.
To address the default risk (the risk that the state or municipality fails to pay on schedule), make sure you buy a fund where you are diversified over several hundred bonds being selected and watched by an experienced money manager. Also, be sure that the average credit quality of the bonds in the fund is AAA, AA, and A by Standard & Poor’s or Moody’s, since this means they will have an extremely low chance of default.
This same Vanguard fund mentioned above has over 9,000 bonds in it, so even if one defaulted, on average it would represent a minuscule part of the retiree’s money. And over 90% of these bonds are AAA, AA, or A rated.
How Do Tax-Free Muni Returns Compare to Taxable CDs?
The big plus of a shorter-term tax-free municipal bond fund is as an alternative to a retiree looking for higher income than a bank CD, but with less risk than being in something as risky as stocks.
To illustrate let’s assume a retiree has been buying shorter-term CDs averaging 1.5% and renewing them every year or two over the last several years. This would mean for every $100,000 sitting in the bank, they're averaging $1,500 in taxable interest per year. If the retiree is in a 24% tax bracket, he or she will give up 24% of this $1,500 in federal taxes, which would be $360, leaving the investor with $1,140 in after-tax interest.
Compare this to taking the same $100,000 and putting it in a short-term, high-quality tax-free bond fund like the Vanguard Intermediate Term Tax Exempt Fund mentioned above, which recently had a yield of 2.7%.
This means on $100,000 the investor would make $2,700 and it’s all federal tax-free. On an after-tax basis instead of earning $1,140, the retiree earned $2,700 picking up an extra $1,560.
While all the pros and cons should be weighed, including the risk, for retirees with a slightly higher risk tolerance, this may be a way to pick up more retirement income.
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