Tax- free bonds can make sense in some cases

Q: I need to buy some new bond investments. I’m torn between longer- term Treasuries and tax- free municipal bonds. Which should I choose?

If you are investing in an IRA or other tax- advantaged account such as a 401( k), it never makes sense to buy tax- free bonds. Money withdrawn from tax- deferred retirement accounts is taxable as ordinary income, no matter how it was invested within the account.

In a taxable brokerage account, the answer is more complicated. Generally speaking, tax- free municipal bonds pay lower interest rates than taxable bonds. What you need to determine is whether the tax advantages make up for the lower rate.

For example, let’s say AAA- rated tax- free bonds with 30- year maturities yield 2.5%, while a 30- year Treasury bond yields 3%. If you’re in the 12% federal tax bracket, this brings your effective yield from the Treasury bond down to 2.64% – the better option. If you’re in the 22% bracket, your yield is 2.34%, so the tax- free bond would be the better choice.

State taxes could make the benefit even better. ( I ignored state taxes for this comparison for simplicity, as states have differing income- tax structures, and laws on municipal bond income.)

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