Municipal bonds and mutual funds are some of the safest investments today, with the former boasting historically low default risks and the latter mitigating risk through diversification. But while many people are well aware of their safety, not everyone can differentiate between these two investments beyond their definitions. If you’ve been struggling to choose between the two, then this post is for you.
The main differences between mutual funds and municipal bonds fall in the following four buckets:
- How investors make money with mutual funds and municipal bonds
- How returns from mutual funds and municipal bonds are taxed
- Investment liquidity with mutual funds and municipal bonds
- Minimum investment required with mutual funds and municipal bonds
To help you distinguish between mutual funds and municipal bonds, this article will focus on the practical differences between these investments and provide a basic overview of what they are. This should clear up any confusion so you can make a better informed choice about what’s the right choice for you, given your individual investment goals.
However, before getting into the nitty gritties of the key differences between these two investment vehicles, let us first briefly discuss what these two investment vehicles are.
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Table of Contents
What Are Mutual Funds?
Mutual funds are investment vehicles that pool money from various investors and invest it in various securities that may include bonds, stocks, and short-term debt. Thus, the holdings of a mutual fund may include municipal bonds, possibly alongside other securities.
Investing in a mutual fund involves buying its shares. When you do that, you buy into the performance of the fund’s holdings.
What Are Municipal Bonds?
Municipal bonds (AKA munis) are debt securities issued by government entities such as municipalities, state governments, and counties. Eligible non-profit organizations may also issue these, as may US possessions and territories, such as Puerto Rico, American Samoa, the US Virgin Islands, and Guam.
When you acquire a muni, you essentially lend money to the issuing government entity to fund daily financial obligations or public projects such as schools, hospitals, roads, and sewer systems.
In exchange, the bond issuer pledges to pay interest regularly (most commonly, this occurs semi-annually). And as with many other debt securities, there’s also the promise that your principal (original investment) will be refunded at maturity.
4 Differences Between Mutual and Municipal Funds
Listed below are the four dimensions on which Mutual and Municipal funds differ:
How Investors Make Money With Mutual Funds and Municipal Bonds
Mutual Funds provide more ways to earn money than municipal bonds. As a mutual fund investor, you have three ways to earn:
- Dividends/interest payments: Once all the expenses are covered, mutual funds pay out almost everything they earn to investors. If the stock held in its portfolio pays dividends, these will be passed on to shareholders. Similarly, interest paid on bonds will be paid out to investors.
- Capital gains distributions: If a mutual fund sells securities that have gained value, capital gains arise. These gains are paid out to investors, usually after capital losses have been deducted.
- NAV gains: A fund’s Net Asset Value (NAV) represents the market value of the securities held in its portfolio. If it gains value, the fund’s value increases, and so does its share value. That effect is reflected in the value of your investment, allowing you to sell your shares at a profit.
On the other hand, investors have one primary method of earning from municipal bonds: interest payments. Selling the bond in the secondary market can also be an option, but it only passes as an income source if you manage to sell at a profit. More often than not, capital gains realized from prematurely selling a municipal bond are lower than the potential gains of holding it to maturity.
How Returns From Mutual Funds and Municipal Bonds Are Taxed
Generally, there are more tax exemptions for a municipal bond investor than a mutual fund investor. To clarify, let’s take a look at how income from both investments is taxed.
Interest from municipal bonds isn’t subject to federal income taxes. If you reside in the issuing locality or state, it’s also exempt from state and local taxes. For instance, a muni issued by New York City could be tax-exempt on three levels: federal, state, and local if you reside and pay taxes in the city.
On the other hand, mutual fund distributions (both dividends and interest payments) are taxable, whether you receive them in cash or choose to reinvest them for more shares. Funds typically report all their distributions via IRS Form 1099-DIV, so there’s no way for shareholders to get around this tax obligation.
Capital gains realized from selling mutual fund shares are also taxable. Additionally, shareholders of a mutual fund may be required to pay taxes on transactions executed by the fund on their behalf.
It’s also worth noting that if you switch between funds of the same company, any transactions arising from that move will be treated as regular sales and purchases. This means that you’re required to capture them in your returns and pay taxes on any realized gains.
To shed more light on the various types of taxes a mutual fund investor is obligated to pay, here’s a table summarizing how the IRS treats the various income types:
| Distribution Type | Description | Federal Tax Treatment |
|---|---|---|
| Long-term capital gains | Net gains you realize after selling shares you’ve held for more than a year. | Taxable at capital gains rates, which are typically lower than those of ordinary income. |
| Short-term capital gains | Net gains realized from selling shares held for no longer than a year. | Often recognized as ordinary dividends and subject to ordinary rates for income taxes. |
| Qualified dividends | Dividends realized from common stock of all domestic companies eligible foreign organizations. | Typically treated the same as long-term capital gains. Some hedging and holding period restrictions may apply. |
| Ordinary/non-qualified dividends | All taxable investment income, excluding long-term capital gains. | Subject to ordinary income rates. |
| Tax-exempt interest | All or part of the interest on specific bonds such as municipal bonds and state bonds. | Federal taxes don’t apply. However, local or state taxes may apply depending on the bond type and where you live. |
| Taxable interest | Interest on all fixed-income securities. | Subject to ordinary income rates. |
| Federal interest | Interest paid on federal debt securities. | Ordinary federal income tax rates apply. State income tax rates don’t. |
| Required distributions | Non-investment income a mutual fund is required to distribute. | Treated as ordinary income and taxed as such. |
| Return of capital | Some or all of your investment principal was refunded. | Non-taxable |
Investment Liquidity With Mutual Funds and Municipal Bonds
Mutual funds are more liquid than municipal bonds. With the former, you can sell your shares to the fund or an authorized broker whenever you want, at the prevailing NAV. You won’t have many hurdles when doing this, except perhaps covering redemption fees.
By contrast, it’s more challenging to sell munis before maturity. Finding a buy on the secondary market will depend on the bond’s demand. That means if the bond has low demand, you’ll struggle to turn it into cash. That’s unlike mutual fund shares, where you’re always guaranteed to find a buyer (the fund itself) when you want to cash in.
Minimum Investment Required With Mutual Funds and Municipal Bonds
Generally, buying shares of a mutual fund requires less initial capital than a municipal bond. For most mutual funds, $1000 to $3000 is enough capital to get started. On the other hand, municipal bonds generally require a minimum investment of $5000.
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Conclusion
As we’ve seen throughout this article, mutual funds are more liquid. They also provide more ways for investors to earn and require a smaller initial investment than municipal bonds.
On the other hand, munis are more tax-efficient, with interest payments tax-exempt at the federal level and potentially tax-free at state and local government levels depending on the holder’s residence.
Recapping, mutual funds differ from municipal bonds in terms of:
- The ways investors can earn from each
- Taxation
- Liquidity
- Minimum required investment
By considering these differences, you should be able to choose the more appropriate investment type for your needs.
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