Invest muni funds in an IRA?

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Dear Dr. Don,
Does it make sense to invest in municipal funds within my IRA? My investment firm is extolling the tax-free component, but there is a 1 percent to 1.5 percent fee per year and from what I understand, my IRA is already tax-free until I access it once I retire.

Would it be beneficial if say, the muni funds earn 3 percent, but half goes to the fee? Should I look for something else safe to put my money in? I am leaning toward investing in CDs.
— M. Muni

Dear M.,
It’s always a good idea to look at investment returns net of fees. Assuming your IRA account is funded with tax-deferred contributions, you’ll be paying income tax on the distributions out of the IRA at ordinary income rates, so the only reason to buy municipal, or muni, bond funds in an IRA is if you’ve got enough confidence in the money manager to expect that the active management of the muni portfolio will give you a total return higher than what you can get in taxable securities. I’d love to say net of fees, but the asset under management, or AUM, fees would hit the account regardless. The investment management fees, however, are relevant.

Munis are currently yielding more than some Treasury maturities. Munis typically trade at yields lower than Treasuries because of the municipals’ tax advantage. Municipal interest income isn’t subject to federal income tax and often is also free of state income tax when a resident of a state buys municipal bonds from a municipal issuer in that state.

Yield on Treasuries versus munis
Maturity U.S. Treasury Muni Muni tax-equivalent yield
2-year 0.62% 0.74% 1.03%
5-year 2.00% 1.72% 2.39%
7-year 2.72% 2.43% 3.38%
10-year 3.35% 3.41% 4.74%
30-year 4.45% 4.88% 6.78%
The municipal tax-equivalent yields shown assume a marginal federal rate of 28 percent.

The $64,000 question is, “Why are some muni maturities trading at higher yields than Treasury securities with the same maturity?” Munis are riskier than Treasuries, but the risk premium is normally less than the tax advantage, keeping yields below Treasury yields. What’s different in the current market environment? There’s a healthy debate going on about it, and I don’t have a definitive answer for you.

An active trader is likely to trade in both securities by buying munis and shorting Treasuries with the expectation that the yield relationship will revert to what it has been in the past. The typical muni bond fund isn’t likely to take that approach given the constraints in the fund’s investment policy. Read a fund’s prospectus to learn more about its investment policy.

If you want to invest in CDs, you don’t need to do it in an IRA with a 1 percent to 1.5 percent AUM fee. Transfer the monies to a bank or credit union IRA CD. You’ll get out from under the investment firm’s fee that would drag down your annual returns on the CDs.

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