Tax‑Free Monthly Dividends: Yields Up to 7.4% Shielded from State and Federal Tax

Are you paying less than you’d like in federal taxes? What about state taxes—does your annual bill feel insufficient?

Forty‑one of the fifty states impose an income tax—about 82% of them. If you reside in one of these states and seek relief on dividend income, continue reading.

Municipal bonds are frequently overlooked. Although their nominal yields appear modest, the interest they pay is exempt from federal taxation—and in many cases also free of state taxes.

Municipal bonds are issued by cities and states to finance infrastructure projects. Imagine a state constructing a new highway; it requires upfront funding and may issue around $30 million in bonds bearing a 6 % coupon. Investors purchase these bonds, providing the necessary capital.

A 6 % yield is attractive, and the tax advantages enhance it further. Since the federal government does not tax the interest, the effective return can rise to 8 % or more.

Additional benefits arise for investors who hold bonds issued by their home state: many states exempt the interest from state taxation as well. In high‑tax jurisdictions, this can push the effective yield above 10 % for top‑bracket earners.

Purchasing individual municipal bonds can be cumbersome and leads to a poorly diversified portfolio. A simpler approach is to invest in a municipal‑bond fund, which holds hundreds of issues across multiple states.

While the tax‑free income is appealing, it is not without risk. A bond’s security rests on the issuer’s ability to tax and spend responsibly. For the federal government, this means the power to print money; for states and municipalities, it depends on their revenue versus expenditures. Historically, investment‑grade municipal bonds have shown very low default rates—Moody’s cites a 0.10 % ten‑year default frequency, compared with 2.2 % for similarly rated corporate bonds—making them among the safest investments after U.S. Treasuries.

States lack the ability to print currency, so investor concern focuses on the fiscal health of each individual issuer.

Interestingly, the states that gather the most tax revenue often exhibit the weakest fiscal balances. Consequently, investors must scrutinize each state’s budget to assess its capacity to meet bond obligations.

Consider the details: a national municipal‑bond fund provides federal tax exemption on its income, but state tax treatment varies. Your home state will exempt only the portion of the fund invested in its own bonds; the remaining 90‑95 % of dividends typically remain subject to state tax.

Nine states levy no personal income tax, including Texas, Florida, and Nevada. If you reside in one of these states, a national fund avoids state tax on all municipal‑bond income.

If you reside in a state that levies an income tax—such as California—continue reading.

California applies a 50 % threshold: if a fund contains less than half California‑issued or federally exempt securities, the state taxes the full dividend, even the interest from California‑based holdings. To avoid this, investors must ensure that at least 50 % of the fund’s assets meet the California exemption.

Illinois takes a stricter stance: holding Illinois municipal bonds via a fund eliminates the state tax exemption, which applies only to direct holdings. Minnesota, meanwhile, demands that at least 95 % of a fund’s assets be Minnesota‑issued bonds; failing that, the entire dividend becomes taxable.

The solution is to invest in state‑specific municipal‑bond funds that are exempt from both federal and state taxes. These funds, offered by firms such as Nuveen and BlackRock, are constructed to satisfy each state’s exemption criteria.

The table below lists the eight largest state‑specific closed‑end municipal‑bond funds. When evaluating them, focus on the premium/discount column to gauge whether you are paying above or below net asset value.

For example, two California municipal‑bond funds are shown: one trades at $1.04 per dollar of underlying bonds, while the other trades at $0.93.

The premium reflects Nuveen’s recent increase in payouts across these state funds, which lifted share prices and eliminated earlier discounts. However, buying at a premium carries risk—similar to purchasing a stock with a high price‑to‑earnings ratio—because upside potential may be limited.

Discounts, by contrast, often represent better value—akin to finding a sale item at the grocery store.

Holding California municipal bonds over the long term warrants caution. In recent budgets, the state withdrew $12.2 billion from its reserve fund and omitted $5.4 billion of planned contributions to achieve a balanced balance sheet.

The following graphic illustrates California’s current and projected fiscal reserves.

A more optimistic view stems from a year‑to‑date rise in the stock market, which could boost capital‑gains tax revenue—a significant revenue source for the state. Additionally, California’s expanding AI sector may provide further fiscal uplift.

Investors should remain cautious with California municipal bonds. While many state budgets are fiscally sound over the long term, a notable trend is the consolidation of state‑specific closed‑end funds into national offerings. New Jersey, Pennsylvania, and Missouri have already been merged into national funds, and Minnesota and Virginia are slated for similar votes this autumn.

Alternatively, several single‑state mutual funds are available from providers such as Fidelity, Vanguard, and Nuveen, with additional options from T. Rowe Price.

An additional advantage of municipal bonds is their monthly distribution schedule, which can appeal to retirees seeking regular income. Some funds offer monthly payouts with annualized yields reaching as high as 16 %.

Further NAC Research:

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Source link