Tax Efficiency with Bond Investing
At Foster Group, tax efficiency is an important part of every client’s financial plan. One area where taxes come into play is bond investing. Even if you think bond investing is as boring as watching paint dry, you may be pleased to hear that you can earn incrementally higher returns through tax efficiency, even in this area of your portfolio.
Consider municipal bonds: debt issued by state and local governments. These bonds are generally exempt from federal income taxes. Municipal bonds, also known as “munis,” by people who are trying to sound sophisticated, can be great investments for people in high tax brackets. In addition to municipal bonds, there are also taxable bonds. Corporate bonds and Treasury bonds, debt issued by the federal government are examples of taxable bonds, bonds that pay interest that is subject to federal income tax. Since municipal bonds are tax-advantaged, investors in high tax brackets are willing to pay more for them, which means they carry a lower rate of return or “yield.” For example, the yield to maturity on the largest taxable bond exchange-traded fund (ETF) was 4.65% in mid-September, 2025, whereas the yield on the largest municipal bond ETF was 3.74%.1
To determine whether taxable or municipal bonds are more appropriate for an investor, it is important to consider the account type and the investor’s tax outlook. Taxable bonds make sense in qualified accounts, such as IRAs and 401(k) accounts. To illustrate the use case for municipal bonds in taxable accounts, consider this hypothetical scenario: Suppose that an investor in the 37% federal income tax bracket put $1 million into both BND1 and MUB1. Based on the current yield to maturities, which would be expected to be worth more in 10 years after taxes?
As illustrated above, municipal bonds would be expected to result in higher after-tax returns for investors in high income tax brackets. In this case, the initial $1.0 million investment in the municipal bond fund would be projected to grow to $1.44 million compared to $1.33 million in the taxable bond fund. Although taxable bonds have higher nominal yields, the tax benefits of municipal bonds are valuable for high earners.
What about investors in low tax brackets? Are the tax benefits of municipal bonds still valuable for investors in the 12% income tax bracket? Here is the same scenario as above but for the 12% tax bracket:
Despite the tax-free interest income of municipal bonds, investors in lower income tax brackets generally can earn higher after-tax yields in taxable bonds rather than municipal bonds. In this scenario, the taxable bond ETF was worth $1.49 million after 10 years, and the municipal bond ETF was worth $1.44 million after 10 years.
At Foster Group, we monitor yield differences between taxable bonds as compared to municipal bonds and consider our clients’ circumstances when determining bond allocations. If you’d like to talk about bonds or tax efficiency, give us a call.
Yield-to-maturity data for Vanguard Total Bond Market Index Fund (BND) and iShares National Muni Bond ETF (MUB) from YCharts.
