Taxable or tax free?
Determining whether a tax-free bond provides a better yield requires looking at both your federal and state tax liabilities. For example, Fred is in the 33% federal tax bracket, pays 5% in state taxes, and needs to decide between a tax-free bond that yields 3.75% and a taxable bond with a 4.5% yield. Fred subtracts 0.38 (33% + 5%) from 1 to get 0.62, then divides 3.75% by 0.62. The result is 6.04%. Since the taxable bond's yield is only 4.5%, the tax-free bond could be a better deal for Fred, since its tax advantages give it a tax-equivalent yield of just over 6%. (This hypothetical example is not intended to represent the performance of any specific security.)
Municipal Bonds and Their Tax Advantages
State and local governments often borrow money to supplement tax revenues and to finance projects such as new highways, buildings, or public works improvements. Such bonds are known as municipal bonds ("munis") or tax-exempt bonds.
Most municipal bonds and short-term notes are issued in denominations of $5,000 or multiples of $5,000. Bond interest typically is paid every six months (though some types of bonds work differently); interest on notes is usually paid at maturity.
Municipal bonds are subject to the uncertainties associated with any fixed income security, including interest rate risk, credit risk, and reinvestment risk. However, the tax advantages associated with munis and their potential ability to provide an ongoing income stream have traditionally made munis an important part of a portfolio.
Why invest in munis?
Municipal bonds have historically appealed to investors in higher tax brackets. Unlike interest on corporate bonds, the interest from municipal bonds is usually (but not always) tax exempt on your federal income tax return. Because of their favorable tax treatment, tax-exempt bonds typically have a coupon rate that is lower than that of a corporate debt instrument with an identical maturity period.
Also, municipal bond interest from a given state typically isn't taxed by governmental bodies within that state, though state and local governments typically do tax munis from other states. However, regulations vary from state to state.
Some states tax both in-state and out-of-state munis, and some tax neither. Consult a tax professional before investing to make sure you understand how your state treats municipal bonds.
The tax advantages of municipal bonds mean that even though a muni's coupon rate may be lower than that of a taxable bond, its after-tax yield could actually be higher, depending on your tax bracket. Generally, the higher your tax bracket, the higher a muni's tax-equivalent yield will be.
Think about what you keep
To accurately compare a tax-free bond to a taxable bond, you'll need to look at its tax-equivalent yield. To do that, you apply a simple formula that involves your federal marginal tax rate--the income tax rate you pay on the last dollar of your yearly income--and any state and local taxes.
To calculate the yield a taxable bond needs to equal that of a tax-free bond, use the following formula:
Add your state and local tax rate to your federal tax percentage.
Subtract the result from 1.
Divide the tax-free bond's annual yield by the result of Step 2. The answer represents the yield a taxable bond would need to offer to equal that of a tax-free bond that is not subject to federal, state, or local taxes.