I Thought Municipal Bonds Were a Fool’s Investment—Until I Wised Up

Why High-Income Physicians Should Consider Them for Tax Benefits

What kind of fool would spend money to buy municipal bonds that only yield a 3–4% return on investment? A CD or savings bond would offer a better return than that!

It turns out I was the fool for thinking that investing in municipal bonds was a foolish financial decision.

In reality, municipal bonds are common investment holdings among wealthy individuals due to their amazing tax benefits.

As my understanding of taxation grew, one day it clicked - I finally realized why municipal bonds make the most sense for high-income individuals.

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What Are Municipal Bonds Anyway?

Municipal bonds are essentially loans to the government - when you buy a municipal bond, you are lending money to a state or local government in exchange for interest payments.

***For the purposes of this discussion, municipal bonds refer only to government-issued bonds and do not include private activity bonds, which are used to finance private projects.

You can even tell the government, “Fool, where’s my money?” LOL

One of the biggest advantages of municipal bonds - let’s use California as an example - is their tax-exempt status.

If you are a California resident and you buy a California municipal bond, the interest you receive may be completely tax-free:

• No federal income tax

• No state income tax (if it’s a California bond and you’re a California resident)

• No 3.8% Net Investment Income Tax (NIIT)

***Alternative Minimum Tax (AMT) may be triggered in certain situations.

Now, let’s compare municipal bonds to taxable bonds and see why this tax advantage matters.

Tax Comparison: Municipal Bonds vs. Taxable Bonds

Let’s assume your household taxable income (married filing jointly) is $750,000 in California. At that income level, taxable bond interest will be taxed at:

• Federal marginal tax rate: 37%

• California state marginal tax rate: 10.3%

• Net Investment Income Tax (NIIT): 3.8%

When you add these up, your total tax on investment income is 51.1%, meaning more than half of your taxable bond interest goes to taxes. Uncle Sam is essentially taking half of the money he gives you - what a gangsta move!

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Example Calculation: Tax-Equivalent Yield

So, you want to determine whether buying municipal bonds or taxable bonds makes more sense. Let’s say a municipal bond pays 4% interest—how does that compare to a taxable bond?

You can use the following formula to convert the municipal bond yield into its taxable equivalent:

• 4% / (1 - 51.1%) = 8.18%

This means a 4% tax-free municipal bond provides the same after-tax return as an 8.18% taxable bond. 8.18% sounds much better, right? And now, imagine trying to find a taxable bond that yields 8.18% - that would be extremely difficult.

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Risk & Stability: Municipal Bonds vs. Stocks

You may ask, “What about the S&P 500?” Its historical return is about 9%. Isn’t that better to invest S&P 500 than a municipal bond that generates the 8.18% pre-tax yield?

Maybe.

While the S&P 500 will likely provide a higher average return over the long term, it can also drop sharply - you could lose 20–30% of your money in a single year. Remember Black Monday (October 19, 1987)? The stock market dropped 20.47% in a single day.

Meanwhile, municipal bonds generally provide a steady positive return, and you typically would not have to worry about significant losses because default rates on investment-grade municipal bonds are low. This makes municipal bonds an attractive option for physicians nearing retirement, where preserving wealth and generating tax-efficient income take priority over chasing high returns.

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Bottom Line

Physicians in high tax brackets who reside in high-tax states, especially those nearing retirement, may find investing in municipal bonds to be a smart way to protect against downside risk while still earning a tax-efficient return.

When evaluating municipal bond interest rates, it’s crucial to compare them to other investments—such as stocks or corporate bonds—using the tax-equivalent yield formula to determine their true return.

Municipal bond interest / (1 - (federal + state income tax rate + 3.8% NIIT)) = Tax-equivalent return.