This Boring Retirement Income Source Has Big Tax Benefits

The dullest retirement income source can sometimes be the secret ingredient to a successful retirement plan. A vanilla investment may help keep retirement exciting rather than stressful. Many of us could use that kind of break; 63% of Americans worry more about running out of money than dying, according to a 2024 Allianz Life survey. While inflation was the most heavily cited contributor in that context, 22% of survey respondents pointed to high taxes as an area of concern.

If you expect to be in a high tax bracket in retirement, there are strategies you can employ to reduce your IRS burden. One is to house savings in a Roth retirement plan, or do a Roth conversion ahead of retirement. Another is to choose your investments strategically. And to that end, you may want to look at municipal bonds.

Municipal bonds, the retirement income source with tax-appeal

Municipal bonds are debt instruments issued by states, cities, and other municipalities to raise capital and fund public projects. They come in two primary forms. First, there are general obligation bonds, which are backed by the full faith and credit of the issuing entity. Second, revenue bonds are backed by a specific revenue stream — for example, a toll road or utility service.

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Municipal bonds are an appealing option for retirees because of their relative stability. As a broad asset class, bonds are considerably less prone to volatility than stocks. But municipal bonds, in particular, are known for their historically low default rates.

Schwab puts the 10-year default rate among investment-grade municipal bonds at one out of every 1,000 bonds issued. Among investment-grade corporate bonds, the default rate was 22 per 1,000. While Schwab cautions that these calculations are based on historical averages, it expects municipal bond defaults to be rare going forward.

But what really makes municipal bonds an appealing investment for retirees — especially those with high incomes — is their tax-friendly status. Municipal bond interest is generally tax-exempt at the federal level. Investors who buy municipal bonds issued by the states they reside in can commonly avoid state and local taxes on their interest payments, too.

To be clear, this tax-beneficial status applies to interest income only, not capital gains associated with municipal bonds. However, many investors — even the wealthy ones — choose to hold income-producing assets during retirement for the financial security they offer. Not having to worry about paying taxes on that interest could be a huge source of relief.

Julio Bonilla, portfolio manager at Schroders, says, "I think overall, municipal bonds are a great diversifier for anyone who pays taxes." He explains, "The muni market has a tendency to zig when the broader markets are zagging."

Be aware of the downsides

However, Gil Baumgarten, founder and president at Segment Wealth Management, calls municipal bonds “a bad investment for people who have a high expectation for returns." As Baumgarten explains, during the distribution phase, many retirees are in a lower tax bracket than they were during their wealth accumulation phase. Because of this, they don't need the tax benefit as badly and may be disappointed with the lackluster returns municipal bonds offer.

Baumgarten also warns that while municipal bonds are "a good liquidity vehicle," they're not good at beating inflation. But in Bonilla's experience, investors who hold longer-term municipal bonds tend to outpace inflation on an after-tax basis.

Bonilla also says that not only are municipal bonds "a safe play" for retirees, but they could be appropriate, in smaller doses, for investors who are still building wealth for retirement.

"High-quality fixed income is a good place to store cash as you wait for opportunities on the equity market," he says.

Baumgarten also says that there is a target audience for a municipal bond holder — namely, a "high-income earner who will be a high-income earner during retirement, who has a personality that demands a high factor of predictability." Some investors, he explains, just can't handle high degrees of uncertainty. Sometimes, that's due to financial trauma experienced earlier in life. But for people who need that stability and peace of mind, municipal bonds fit the bill.

Will the end of TCJA affect munis?

The Tax Cuts and Jobs Act (TCJA) of 2017 did not negatively impact municipal bond investors. However, those changes cost municipal bond issuers the option to advance refund bonds. Previously, issuers could refinance their bonds prior to redemption without losing tax-exempt status. But investors themselves didn’t lose any tax breaks.

However, the TCJA will expire at the end of 2025. And if certain provisions change or aren’t renewed, it could affect municipal bonds — and make them a more or less appealing investment.

The TCJA lowered the top marginal individual tax rate to 37% from 39.6%. If the TCJA isn’t renewed and the top tax rate increases, it could make municipal bonds that much more appealing to investors in that top bracket.

The TCJA also raised the exemption threshold for the alternative minimum tax (AMT). But some municipal bonds — namely, private activity bonds — are subject to AMT. If the AMT threshold is lowered, the benefit of holding municipal bonds could be reduced.

Furthermore, the TCJA put a $10,000 cap on the state and local tax (SALT) deduction. If the cap is retained once the TCJA expires, it could drive more retirees in high-tax states to load up on municipal bonds to compensate for a limited SALT benefit.

However, President Trump has pledged to repeal the SALT cap. If that happens, it could erode the benefit of municipal bonds in high-tax states, though not necessarily to the point where these assets lose their appeal completely.

Given that Republicans control the Senate, it’s likely that the TCJA will be extended to some degree. Even if the top tax rate holds at 37%, there can still be benefits to holding municipal bonds in retirement.

Could municipal bonds lose their tax-exempt status?

In the past, lawmakers have toyed with the idea of changing the federal tax exemption for municipal bond interest, especially to offset the TCJA, which could cost the government $4.6 trillion over the next decade. However, eliminating that benefit is unlikely because that tax exemption is crucial to financing U.S. infrastructure.

Keeping municipal bond interest tax-exempt comes at an estimated cost of $40 billion annually to the federal government, or $400 billion over the next decade. But that would only make a small dent in the $4.6 trillion that needs to be offset.

However, in the unlikely event that municipal bonds were to lose their tax-exempt status going forward, previously issued bonds would probably be grandfathered into the exemption. If so, that would likely drive municipal bond values way up, which is another reason for retirees across all income brackets to consider investing in them sooner rather than later.

Don't go it alone

While municipal bonds could be a great addition to your portfolio, Bonilla thinks investors should seek the help of a financial adviser or portfolio manager when acquiring them. "The muni market is not a straightforward market. There are a lot of quirks," he insists.

Municipal bonds are commonly tied to specific revenue streams. But Bonilla cautions, "You may find that the revenue source is something different than what you expected."

He also warns investors to be mindful of municipal bonds' structure and call dates. Although he recommends 30-year municipal bonds, "most munis are issued with a 10-year call option, so it's rare that bonds will stay out there to maturity," he explains. So, all told, "You have to do your due diligence and analysis on what you're buying."

Read More

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• AMT and Pass-Throughs Add Complex Layers to 2025 SALT Tax Planning
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