As it’s been said before, “there is no free lunch,” and it is no different for municipal bonds. The rules of asset diversification apply even in the compelling case of tax-free income. Bonds have historically had little correlation to equities except in market crisis situations, so creating a portfolio of both equities and bonds makes a whole lot of sense as a long-term investor.
But when considering other fixed-income vehicles such as annuities or real estate, which both generate taxable portfolio interest, individual municipal bonds make a good alternative. Take the case with your typical annuity (fixed or variable) that carries an average 2 percent to 3 percent annual expense charge when you consider administrative, mortality and expense, and mutual fund costs. And although you may not see it, don’t forget there will be a commission paid to the broker that sold you the annuity. First year charges can easily exceed 8 percent.
Finally, you still have to pay taxes on the annuity income stream on all gains beyond your cost basis. Alternatively, you can invest the same amount into a diversified municipal bond portfolio and pay no taxes and receive tax-free income until the bonds are called or mature. As an added bonus, your estate will receive a step-up in basis at your date of death, greatly reducing any potential capital gains.
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