Looking for an Iowa Municipal Bond Fund? It Doesn’t Exist – Here’s How (and Why) We Invest in Iowa Municipal Bonds
Iowa municipal bonds can save Iowans a lot of money. But, many investors are not investing in the right municipal bonds or funds to maximize their potential tax savings.
Municipal bonds provide income that is not subject to tax at the Federal or the state level. But ONLY IF the municipal bonds are issued in your state.
For residents in high tax states like Iowa, investing in any one of today’s large municipal bond ETFs or mutual funds is not giving you all the tax breaks you are eligible for.
Iowans have a few extra hoops to jump through in order to invest in municipal bonds that exempt them from both federal AND state taxes. However, the extra hassle can save you thousands in taxes.
Here’s a quick review of how municipal bonds differ from other bonds, and why Iowans should not be investing in big municipal bond funds from Vanguard, iShares, or other large fund companies.
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Why Invest in Iowa Municipal Bonds – Municipal Bonds vs Other Bonds
For Iowans specifically, municipal bonds can save investors a lot of money in taxes. Let’s take a look at an example.
Let’s compare 2 different bonds, a corporate bond and an Iowa municipal bond. First, a corporate bond from a local company, Rockwell Collins:
The bond yields 3.7% and matures in late 2023. That means an investor who buys this bond will receive 3.7% of their investment per year until 2023.
The second bond is an Iowa municipal bond issued by the Waukee Iowa community school district that yields 3.25%:
At first it may appear that the Rockwell Collins bond, which yields 3.7%, would give an investor a higher income than the Waukee Iowa municipal bond, right?
No – and this is why municipal bonds can be such great investments.
For households in high tax states (like Iowa!) municipal bonds may provide higher returns than today’s corporate bonds.
Let’s look at an example to see how investing in Iowa municipal bonds can provide higher returns for Iowans today:
Let’s say you invest $100,000 in the Rockwell Collins bond and $100,000 in the Waukee Iowa municipal bond.
For the Rockwell Collins bond - 3.7% interest on $100,000 gives you $3,700 in annual income. But at the end of the day, you don’t pocket $3,700. That’s because interest from the Rockwell Collins corporate bond, like all corporate bonds, is taxable at the state and federal level.
First, you pay federal income tax (let’s assume you are in the 24% tax bracket). That’s $888 in taxes. Then, you pay 8.98% Iowa state income tax – That’s another $332 in taxes.
In total, you receive $3,700 in income from the bond, but pay $1,220 in taxes. A net tincome of of just $2,480 after taxes. Ouch!
We would say that this bond has a “after tax yield” of 2.48%. That is, after you pay the taxes on the bond, you are left with an interest of 2.48%. That doesn’t sound nearly as good as 3.7%.
THE IOWA MUNICIPAL BOND IS MUCH MORE TAX EFFICIENT.
Remember, this bond had a 3.25% yield.
If you invested that same $100,000 in our municipal bond, you would receive $3,250 in annual income.
And best of all - You pay no taxes. No 24% federal tax, no 8.98% state of Iowa income tax. You keep all $3,250!
So, although this bond looked like it had a lower interest rate – an investor would be much better off buying this municipal bond than the Rockwell Collins corporate bond.
Investing in Municipal Bonds – Not So Easy in Iowa.
Municipal bonds offer a lot of benefits, but if you want to buy - where do you go?
You would think it would make sense to just search Vanguard, or any other large mutual fund company for a municipal bond fund, right?
Here’s one of Vanguard’s largest municipal bond mutual funds:
But its not that easy. Iowans looking to invest in Iowa municipal bonds will be very disappointed, because large municipal bond funds such as this one hold very few municipal bonds from Iowa:
Remember, Iowans only get a break from state income tax for municipal bonds from Iowa. And if you read the fine print of this fund (or any other municipal bond fund), only 0.37% of your income from this fund would be eligible for a state tax break.
What does that mean for a hypothetical $100,000 investment in this Vanguard fund compared to if you had invested solely in Iowa municipal bonds?
The Vanguard fund currently yields 2.7%. That means your $100,000 investment will provide $2,700 in income per year. Although you do not have to pay federal taxes on this income, you will need to pay 8.98% Iowa state income tax, or $242. In total, you would collect $2,458 after taxes.
Investing in Iowa municipal bonds would save you that $242. Plus, Iowa municipal bonds today typically have higher yields than the municipal bonds from other states that make up these big municipal bond funds.
So how do you invest only in Iowa municipal bonds easily with a single mutual fund or ETF?
INVESTING IN IOWA MUNICIPAL BONDS
You can’t. There are no Iowa municipal bond funds.
Residents of other high tax states have it easy, as there are mutual funds that invest solely in municipal bonds from their state:
But us Iowan’s aren’t that lucky. So what do we do?
There is No Iowa Municipal Bond Fund – Here’s What to Do Instead to Get “Double Tax Exemption” Bonds
Iowans are stuck investing in individual municipal bonds if they want to take full advantage of the tax breaks available. The bonds from our state that qualify for both federal and state tax breaks are typically referred to as “Iowa double tax exempt bonds”.
For an investor not used to investing in bonds, finding these can be complicated and intimidating. Here’s what a typical screen will look like when we search for Iowa municipal bonds for our clients:
But, to make things even more complicated, its not as simple as just picking any bond on the list and buying it. Iowa has pretty complicated tax laws that limit what types of municipal bonds give investors a state tax break.
If you remember one thing from this post, let it be this:
NOT ALL IOWA MUNICIPAL BONDS ARE TAX FREE (AT THE STATE LEVEL)!
What does it take for a bond to qualify for double tax exemption? Here’s some of the specific criteria from the Iowa tax code:
So, you need to go through each of the bonds available to you and verify that they meet one of the exemptions above to qualify for the Iowa state tax exemption.
(Or, contact us and let us do the work for you – the tax savings of municipal bonds may more than pay for our fee!)
OTHER BENEFITS OF IOWA MUNICIPAL BONDS
One of several unique benefits available for those who delve into the details of Iowa’s municipal bonds is identifying a few types of the bonds listed above that provide not only tax free income, but also tax free capital gains – which is very rare for municipal bonds and certainly does not come with municipal bond funds.
What does this mean? Certain municipal bonds may be better than others for certain scenarios. Knowing what types of Iowa municipal bonds are best can save you additional money from taxes.
For example, with today’s rising interest rates, Iowa municipal bonds may be, or will soon be, trading below their par value (typically $100). IF you can find certain municipal bonds that not only provide tax free income but also tax free gains – those bonds currently priced below par may provide higher after-tax returns than other municipal bonds.
Our Services for Iowa Municipal Bond Investors
At Hylland Capital Management, we provide investment management for those looking to invest in Iowa municipal bonds.
Not sure if municipal bonds are right for you? Not sure how to choose the right municipal bonds?
That’s why we’re here. We manage client assets invested in municipal bonds. We have done the due diligence of researching the bonds available, evaluating their credit quality, and ensuring that they qualify for both a federal and state tax break. That saves you a lot of time, and saves you money in taxes as well!
The lack of a universal Iowa municipal bond fund makes it more difficult for Iowans to invest in municipal bonds. However, the variety of individual municipal bonds and Iowa’s unique tax laws give investors who spend the time researching the details of the outstanding bonds a big potential advantage.
Hylland Capital Management is a Fiduciary, Fee-Only investment advisory firm based out of North Liberty Iowa, and serving clients across the state (and country). We offer holistic financial planning and investment advice. Municipal bonds are just a small part of what we do.
Ready to see what we can do for you? We offer free, no obligation consultations to everyone.