The Municipal Beats the Corporate by Three Basis Points - and Only Because of the State
Marcus and Elena, both 54, file jointly, sit in the 32% federal bracket, pay 5% state income tax, and have MAGI well above the net investment income tax threshold. Their retirement accounts are already filled with taxable bonds, leaving $400,000 to invest in the taxable account. Two candidates are on the table. Bond A: an in-state AA-rated general obligation municipal, ten-year, 3.05% coupon, non-callable, not a private activity bond. Bond B: an A-rated corporate, ten-year, 5.10% yield to maturity, non-callable. Their adviser also pitches a non-traded REIT with a 9.5% upfront load and a 5.5% annual distribution, which the wholesaler calls 'bond-like income with real estate upside.'
1. Compute the after-tax outcome for each bond for Marcus and Elena and recommend one. Show the arithmetic, including every marginal rate that applies to each.
Read the worked answer
Rates that apply.
- Corporate interest: 32% federal + 3.8% NIIT + 5% state = 40.8%. The SALT cap means there is no meaningful federal offset for the state tax.
- Municipal interest: exempt from federal, excluded from net investment income for NIIT purposes, and exempt from state tax because the issue is in-state. Marginal rate = 0%.
Corporate, Bond B. 5.10% × (1 − 0.408) = 3.02% after tax.
Municipal, Bond A. 3.05% × (1 − 0) = 3.05% after tax.
Taxable-equivalent check. 3.05 ÷ (1 − 0.408) = 5.15%, versus the corporate's 5.10%. The municipal wins.
Why the obvious shortcut fails. Using only federal tax and NIIT (35.8%), the municipal's TEY is 3.05 ÷ 0.642 = 4.75% - below the corporate's 5.10% - and you would wrongly pick the corporate. The state exemption is worth five points of yield here, and it is the entire swing factor.
How thin the margin is. Three basis points. It flips if their bracket falls in retirement: at 24% + 3.8% + 5% = 32.8%, the corporate yields 5.10 × 0.672 = 3.43% after tax and wins outright. It also flips if they relocate to another state.
Recommendation. Buy the municipal for the taxable account, but only on the assumption they hold to maturity at the 32% bracket. Do not pay up above the institutional market to get it - three basis points disappears inside a wide dealer spread.
2. Evaluate the non-traded REIT pitch. Is a 5.5% distribution 'bond-like income' for this couple in a taxable account?
Read the worked answer
Start with the load. At a 9.5% upfront load, $100,000 buys about $90,500 of NAV. The $9,500 is a realized loss on day one that must be recovered before the investor is whole.
Then the distribution. 5.5% on NAV is 5.5% × 0.905 ≈ 4.98% on dollars actually invested - below the corporate bond's 5.10% pre-tax and well below the municipal's 5.15% TEY. 'Bond-like' is doing a lot of work in that sentence.
Distribution is not return. Non-traded REIT distributions frequently include return of capital, which reduces cost basis and is not earnings. With no daily mark, a steady distribution can mask NAV erosion for years.
The tax treatment is the opposite of bond-like. REITs must distribute at least 90% of taxable income, and those distributions are generally ordinary income - taxed at 40.8% for this couple. The municipal is taxed at zero. In taxable space, ordinary-income REIT distributions are the worst of the three candidates, not the best.
Liquidity. Repurchase programs are typically capped - often 2% of NAV per month and 5% per quarter - and can be suspended; several gated in 2022 and 2023. A 54-year-old couple with a $400,000 taxable account could easily need this money before a window opens.
Suitability. Many firm and state guidelines cap non-traded REITs near 10% of liquid net worth, which here would be about $40,000 - and a REIT belongs in the IRA, not the taxable account.
Recommendation. Decline and document why. The wholesaler's characterization is marketing; the representative still needs a reasonable basis, and 'bond-like' is not one.
3. Elena asks why they do not simply buy the municipal bond inside the IRA, since it is the better bond. Answer her.
Read the worked answer
Because the IRA is already full of bonds, and a tax-exempt bond inside a tax-deferred account wastes the exemption. IRA distributions are eventually taxed as ordinary income, so the municipal's interest is taxed on the way out - you pay the lower yield and get none of the benefit. Strip away the exemption and you are simply holding a bond that yields 205 bp less than the alternative.
The rule is asset location:
- Tax-deferred: ordinary-income assets - the corporate bond, REITs, high-yield, anything taxed at 40.8%.
- Taxable: the municipal bond, broad index equity funds, and anything getting qualified-dividend or capital-gain treatment.
Run the numbers her way: the corporate bond yields 3.02% after tax in the taxable account but a full 5.10% inside the IRA. That 208 bp difference is what the tax deferral is for, and it is why the corporate bond is the first thing to buy when IRA space opens. The municipal bond is what stays outside.
One corollary worth saying out loud: as their IRA space grows, sell the municipal and move taxable bonds in - do not hold both at once and call it diversification.