If your employer offers a 401(k) and you are taking advantage of this benefit, pat yourself on the back. You deserve it. But you can't stop there; you have to take a look at what's going on within your 401(k), too. Unfortunately, making the right investment choices can be a daunting task when dealing with any account, let alone a specialized one like a 401(k). That said, here's an easy win: you don't want to buy municipal bond funds in your 401(k). This is what you need to know to understand why.
The point of the thing
A traditional 401(k) is a great savings tool that offers huge tax advantages. Like a traditional IRA, the money you put into a 401(k) reduces your taxable income in the year of the contribution. That, in turn, lowers your tax bill for the contribution year. Thank you, Uncle Sam! But it gets even better.
While your money is in the 401(k), all of the investment income and capital gains generated within the account avoid taxation, too. This allows your portfolio to compound tax-free. Put another way, you'll have more money working for you over time, which increases the already incredible power of compounding. Thank you again, Uncle Sam.
The trade-off for these wonderful benefits is that any money pulled out of a traditional 401(k) (and a traditional IRA) during retirement gets taxed as ordinary income. The government has to get its cut at some point. You may already know all of this, but step back and consider what this means for your investments.
Don't turn good things into bad things
Most investments will work well within a 401(k), except for those that already have tax advantages built into them. For example, a municipal bond fund like Fidelity Tax-Free Bond Fund (NASDAQMUTFUND:FTABX), which buys bonds issued by local governments from all across the United States, would be a lousy option to include in your 401(k).
The cash generated by selling muni bonds helps fund local governments and large municipal investment projects. To incentivize investors to put their money into these bonds, which often have lower yields than taxable bonds, the government provides a tax incentive. The income generated by muni bonds avoids taxation at the federal, and often state, level. If you put Fidelity Tax-Free Bond Fund into a 401(k) (or a traditional IRA), you would take tax-advantaged income and turn it into taxable income when you pull it out in retirement.
And that's a big deal. Fidelity Tax-Free Bond Fund's SEC yield is 2.6%. But the tax-equivalent yield is roughly 4%, assuming you are in the 35% tax bracket. A tax-equivalent yield is essentially the yield you would have to earn on a taxable bond to match the income you generate from a municipal bond. (The formula for calculating this figure is: Tax-Equivalent Yield = yield / (1 - tax rate).) The difference between 2.6% and 4% is a big one, and you would effectively throw that benefit away if you put Fidelity Tax-Free Bond Fund into a 401(k) or traditional IRA. Let's look at some more examples.
Vanguard Long-Term Tax-Exempt Fund (NASDAQMUTFUND:VWLTX) has an SEC yield of 2.77%. The tax-equivalent yield to match that is 4.26%. To be fair, that's looking at the highest tax bracket, and the yield difference drops as tax rates go down. But even at the 22% bracket, the tax-equivalent yield for Vanguard Long-Term Tax-Exempt Fund is 3.55%, a still-notable difference that you wouldn't want to negate by putting the fund into a 401(k).
American Funds High-Income Municipal Fund (NASDAQMUTFUND:AHMFX) has an SEC yield of 3.36%. That yield is a function of the fund buying higher-risk muni bonds, often issued by municipalities with low credit ratings, or by buying muni bonds with limited protections for investors. The tax-equivalent yield for this fund is nearly 5.2% at the 35% tax bracket. For an investor with a high risk tolerance, this could be a very enticing investment choice. But, like the Fidelity and Vanguard funds above, you throw away that difference if you put American Funds High-Income Municipal Fund into a 401(k) or traditional IRA.
I could keep providing examples, but by this point, you should get the big picture. If you put a tax-advantaged investment product like a municipal bond fund into a 401(k), you will effectively destroy the tax advantage and turn any income you generate from the fund into fully taxable income. That's a big mistake and one that's easy to avoid by simply not buying muni bond funds in your 401(k) or traditional IRA.