At a wedding in 2007 I met a retired treasurer from a prestigious east-coast university.  He told me that all his investments were exclusively in insured municipal (muni) bonds.  The returns he received were good, sufficient to cover all his expenses, and were practically guaranteed.  But the best part of the muni investments, as he put it, was that “I don’t have to pay any taxes on them.”

Then came 2008, and the muni bond market got turned on its head.  Insurers went bankrupt and bond yields dropped to their lowest levels in recorded history.  Today it’s impossible to buy muni bonds in quantities under $1 million without paying exorbitant sales charges or spreads (although there are now numerous muni bond mutual funds and ETFs from which to choose).  And as far as safety goes, few muni bonds remain insured, putting the risk of bankruptcies like that of Detroit or Puerto Rico squarely on the shoulders of the bond holders, many of whom are retirees with those very same risk-averse attitudes.  Despite these changes, muni bonds (especially muni bond funds) can still be a good investment today, and still offer significant tax benefits.  But investors should be aware that not all the gains from a muni bond or fund are tax free, and that some muni bonds (and the funds that hold them), to paraphrase George Orwell, are more tax free than others.

Let’s start with the basics.  There are two ways muni bond funds return income to their owners.  The first is from interest paid by the bond issuers, and that interest is always federal tax free.  If a fund is holding bonds issued in your state, the interest from those bonds may also be state tax free.  But it depends on the state.  Some states will allow all the interest in the fund coming from that state’s bonds to be treated as tax free income, while others such as California require that a certain minimum percentage of the fund’s interest (typically 50%) come from bonds issued in that state in order to qualify for a tax deduction.

The second source of income is capital gains.  When bonds in the fund are sold at a higher price than when they were purchased, the difference represents a capital gain (or a loss if the reverse occurred).  Changes in interest rates are one factor that impacts capital gains and losses, but there are numerous others as well.  And although such gains tend to be less dramatic than those from stock transactions, you can still generate some pretty large capital gains with munis when economic and financial conditions are right.  Unfortunately, the capital gains from muni bond sales are not tax free at all.

Next we come to the alternative minimum tax (AMT).  Very briefly, it is a parallel income tax system designed to prevent high income taxpayers from avoiding their fair share of income taxes.   And certain muni bond interest is subject to AMT (that is, not tax free).  It depends on the classification of the bond.  Public purpose bonds are used by municipalities for the benefit of the public.  These include money borrowed to build schools, improve roads or bridges, upgrade libraries, etc.  Such bonds are not only ordinary income tax free (as described above) but also AMT tax-free.  On the other hand, bonds issued to support individuals or companies, such as for housing, student loans, or sports stadiums, are classified as private purpose and are taxable under the AMT (with a tax rate of 26% – 28%).  If you invest in muni bond funds and may be subject to the AMT, it’s pretty important to know the percentage of your fund’s holdings in each category so that you can per-determine the tax consequences.  Unfortunately, many funds do not make it easy to find that information.

When I think about munis, that retired treasurer often comes to mind.  These days it’s very difficult to eke out a living as a retiree solely from munis, with returns currently miniscule and safety having all but disappeared.  I would never recommend investing all your money in any one asset class, let alone muni bonds or funds.  Nonetheless, they can still provide good diversification as part of a well-rounded portfolio, as well as excellent tax benefits.  But those benefits do come with limitations.  Be sure to understand them before investing.