Why Buy Municipal Bonds Through a 401(k)?

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?


-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.

Get more news, money-saving tips and expert advice by signing up for a free Bankrate newsletter.

Ask the adviser

To ask a question of the Retirement Adviser, go to the "Ask the Experts" page and select "Retirement" as the topic. Read more Retirement Adviser columns and more stories about retirement.

Bankrate's content, including the guidance of its advice-and-expert columns and this website, is intended only to assist you with financial decisions. The content is broad in scope and does not consider your personal financial situation. Bankrate recommends that you seek the advice of advisers who are fully aware of your individual circumstances before making any final decisions or implementing any financial strategy. Please remember that your use of this website is governed by Bankrate's Terms of Use.