Explore how municipal bonds can provide tax-free income for high-net-worth investors, contribute to diversified portfolios, and help enhance tax efficiency.

How Municipal Bonds Can Provide Tax-Free Income

Municipal bonds offer a way to generate income while potentially reducing your tax burden—making them a valuable consideration for high-income investors. Issued by state and local governments to finance infrastructure and community services, these investments may provide federal (and in some cases, state) tax-exempt interest income.

With guidance from EP Wealth’s tax and investment professionals, you can explore how municipal bonds might complement your broader financial strategy—supporting both cash flow needs and long-term planning priorities.

What Are Municipal Bonds and Why Do They Exist?

Municipal bonds, or "munis," are debt securities issued by state and local governments to finance various public projects ranging from public schools to professional sports stadiums. They offer high-net-worth investors a tax-efficient way to generate income, often exempt from federal and sometimes state and local taxes.

The two main types are general obligation (GO) bonds, backed by a government’s taxing authority, and revenue bonds, supported by income from specific projects. Their tax advantages and relative stability make munis a potentially valuable addition to a diversified portfolio.

Tax Advantages of Municipal Bonds

One of the key reasons investors consider municipal bonds is their federal tax-exempt status. Interest earned on most muni bonds are not subject to federal income tax, and in many cases, bonds issued within an investor’s home state may also be exempt from state and local taxes.

This tax treatment can be particularly appealing for high-income individuals. While the nominal yields of municipal bonds may appear lower than those of taxable bonds, the after-tax income potential can be competitive.

How to Calculate the Tax-Equivalent Yield (TEY)

Investors often use the tax-equivalent yield (TEY) to help evaluate whether to purchase municipal bonds or taxable bonds. This calculation estimates the pre-tax yield of a taxable bond that would need to be earned to match the tax-free municipal bond income.

• Formula: Tax-Equivalent Yield = Tax-Free Yield / (1 - Tax Rate)
• Example: An investor subject to a 40.8% federal income tax rate earning 3% from a municipal bond would need a taxable bond yielding approximately 5.07% to achieve the same after-tax return.

Risks and Considerations

Although municipal bonds are generally considered less risky than equities, they are not without potential drawbacks:

• Credit Risk: Not all issuers carry the same creditworthiness.
• Interest Rate Risk: Rising rates can decrease the market value of existing bonds.
• Call Risk: Some bonds may be redeemed early by the issuer, potentially impacting the predictability of the income stream.
• Liquidity Risk: With over 50,000 issuers, the municipal bond market is large, leading to infrequent trading of most bonds and limited liquidity for specific securities.
• Tax Considerations: Interest of municipal bonds are often tax-free, but they may be taxable at the state level if the bonds are issued out of the investor’s state of residency. Additionally, interest from private activity bonds may be subject to the federal Alternative Minimum Tax (AMT).

Where Municipal Bonds Fit in a High-Net-Worth Portfolio

Municipal bonds can play a versatile role in a high-net-worth portfolio, offering income generation with potential tax advantages, diversification from equities and taxable fixed income, and flexibility to meet short-term and long-term financial needs.

For some investors, munis are a strategic complement to other income-producing assets such as annuities, dividend-paying stocks, and corporate bonds, enhancing overall tax efficiency and portfolio balance.

EP Wealth professionals can help evaluate whether municipal bonds align with your income needs, risk tolerance, and overall portfolio strategy.

Accessing Municipal Bonds: Three Common Methods

High-net-worth investors have several options for gaining exposure to municipal bonds, each offering varying levels of customization, control, and professional management.

Direct Purchases

• Build customized bond ladders for predictable cash flow
• Offers control over credit exposure and maturity schedule
• Requires ongoing due diligence and analysis

Bond Funds and ETFs

• Access diversified municipal portfolios
• Managed by professionals with broad market access
• Subject to fees, interest rate sensitivity, and potential volatility in share price (NAV)

Separately Managed Accounts (SMAs)

• Tailored for high-net-worth investors
• Custom strategies by geography, maturity, or credit quality
• Offers increased oversight and control with a personalized structure

Alternative Municipal Strategies for Affluent Investors

Affluent investors often seek tailored solutions beyond traditional municipal bonds to meet their complex financial needs. While traditional municipal bonds appeal to many, some investors may consider alternative approaches:

• High-Yield Munis: Lower-quality bonds that have higher income potential with increased risks
• Private Placements: Access through wealth management platforms for customized bond deals
• Taxable Municipal Bonds (e.g., Build America Bonds): May still be tax-efficient in certain accounts, such as IRAs, or when the exemption from state income taxes is less impactful

Exploring these options can help align income generation with broader tax and investment strategies. With professional guidance, these alternatives can complement a sophisticated wealth plan designed for long-term stability.

Municipal Bonds in Trusts and Estate Strategies

Municipal bonds can serve as a valuable component of your long-term estate and trust planning strategies, particularly within irrevocable trusts. In certain cases, they may provide beneficiaries with federally tax-free income and help support broader family wealth transfer goals.

However, the tax treatment of bond income within a trust can vary based on the trust’s structure and the grantor’s involvement. Working with legal and tax professionals to integrate these assets into your estate plan properly is essential.

How EP Wealth Incorporates Tax-Aware Income Planning

At EP Wealth, our advisors support clients with holistic financial planning, which includes helping evaluate municipal bonds in the context of long-term goals, income needs, and state-specific tax environments.

Our approach includes:

• Reviewing the role of tax-advantaged income in the overall portfolio
• Assessing liquidity and risk tolerance in fixed-income allocation
• Discussing how municipal strategies align with estate and trust planning goals

Municipal bonds may be a valuable option for investors seeking tax-aware strategies for income and diversification. As with any investment, evaluating these bonds in the broader context of financial planning, particularly tax and estate considerations, can help investors make informed decisions that align with their goals.

Connect with an advisor at EP Wealth to get started.

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• Request an appointment with an EP Wealth Advisor when you have a minimum of $500,000 in investable assets – which includes qualified retirement plans (IRA, Roth IRA, 401(k), taxable brokerage, cash (savings / checking) and CDs. Investable assets do not include your home, vehicles, or collectibles.
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• Information presented is general in nature and should not be viewed as a comprehensive analysis of the topics discussed. It is intended to serve as a tool containing general information that should assist you in the development of subsequent discussions. Content does not involve the rendering of personalized investment advice nor is it intended to supplement professional individualized advice.  
• EP Wealth Advisors (“EPWA”) makes no representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information presented. All expressions of option are subject to change without notice.
• All investment strategies have the potential for profit or loss. Different types of investments and investment strategies involve varying degrees of risk, and there can be no assurance that any specific investment strategy will be suitable or profitable for a client’s portfolio. The risk of loss can never be eliminated even if working with a professional.
• Laws vary by state. The information presented herein is intended to be general in nature and may not apply to your state of domicile. Please consult local legal counsel to determine the best practices for your state.
• Please consult with a CPA, tax professional, and/or attorney regarding your specific situation before implementing any of the strategies referenced directly or indirectly herein.