Over the past month or so, I’ve covered a lot of ground on bonds and bonds funds. If you are just joining us or want to revisit one of the topics I’ve covered, the five installments from my Bonds 101 series are listed below:

I’ve also discussed Vanguard’s taxable bond funds—here and here. But the bond discussion would not be complete without a conversation about municipal bonds and taxes.

As a Vanguard investor, you’ve bought into the idea of keeping costs low. Well, from an investor’s viewpoint, taxes are a cost; reducing the amount of income and capital gains that you and I keep. So, I’m willing to bet you are eager to hear about strategies that can reduce your tax bill. Municipal bonds are one way to do that—the income they pay out is exempt from taxation to varying degrees.

However, before diving deep on Vanguard’s tax-exempt bond funds, there are some basics (and not-so-basics) of municipal bonds that we need to cover. In this article, I’ll cover the fundamentals of the municipal bond market, explain why tax-exempt funds are best held in your taxable brokerage account and give you the tools to decide if that makes sense for you.

Here’s one rule of thumb: Hold corporate and Treasury bonds (and bond funds) in your retirement accounts, and if you are in one of the top three tax brackets (paying a 32% tax rate or higher), consider owning municipal bond funds in your taxable (brokerage) accounts.

All that said, keep in mind that minimizing your tax bill isn’t your real aim—maximizing your after-tax returns is … and they are not always the same thing. I’ll get into that as we dive in.

Key Points
  • The income paid by municipal bonds is not taxd by the federal government.
  • Rule of thumb: Hold corporate bonds in your IRA and tax-exempt bonds in your taxable (brokerage) account ... if you are in one of the top tax brackets.
  • Minimizing your tax bill isn't the same as maximizing your after-tax returns.

Fund Local Projects, Get a Tax Break.

Just as the U.S. government and businesses borrow money for a wide range of purposes, states, cities and towns have their own funding needs for projects of all shapes and sizes. Repairing roads, expanding a sewage plant or building a new school are just a few of the projects that investors finance by purchasing bonds issued by these municipalities. That’s why they’re called municipal or “muni” bonds.

What sets muni bonds apart from Treasury, corporate and mortgage-backed bonds is taxes. When you lend to a municipality by purchasing their bonds, the interest they pay is not taxed by the federal government. And if you live in the same state as the issuer, the income is not taxed by the state, either.

Hence, muni bonds are also called “tax-exempt” or “tax-free” bonds—though, of course, as I just mentioned, they may not be fully tax-free.

When you buy a municipal bond, you are helping to fund a project in your community ... and you get a tax break to do it. 

Muni bonds come in different flavors based on how the money will be paid back.

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