Buy municipal bonds through 401(k)?

Dr. Don Taylor, Ph.D., CFA, CFP, CASL

Dear Retirement Adviser,
Can I buy municipal bonds through my 401(k)? As I look to diversify my investments, I think this is something that could be worth considering. What can you tell me about the possible pluses and minuses?

Thanks,
-- Frank Fixates

Dear Frank,
You can buy municipal bonds through your 401(k). I question why anyone would want to do it. Your 401(k) is a tax-deferred retirement account. Sometimes called "munis," municipal bonds are tax-exempt investments. I'll do you a favor and spare you the long tax lecture.

You'd be investing money in tax-exempt securities. Distributions out of the 401(k) plan are taxable. The coupon interest on the munis can be tax-exempt when held in a taxable account.

You can earn a return on a muni bond in one of two ways: through the coupon interest payments or through price appreciation and capital gains. If you think you've got a hot hand in timing your investments in munis, then I'd argue that you're better investing in muni bonds in taxable accounts than you are in a tax-deferred retirement account like your 401(k) since the coupon income is tax-exempt. Any long-term capital gains are taxed at a lower rate than your marginal income tax rate.

There are important differences between investing in such individual municipal bonds or securities and investing in a municipal bond fund. One has more control investing in individual bonds, while "do-it-yourselfers" lose the professional investment management involved in a bond fund.

Retail investors looking for reasonable pricing in the purchase or sale of municipal bonds in secondary trading can certainly face some challenges. But there's also a potential downside when having to pay mutual fund fees and expenses.

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