We covered the basic tax benefit of municipal bonds in chapter 2. The key benefit from municipal bonds is that the interest received from municipal bonds is free from federal income taxes and can be free from state income taxes as well. With municipal bonds, everything comes down to taxes. If you are not going to benefit from the tax-exemption, you will earn more with taxable bonds. For instance, highly rated municipal bonds may actually yield less than even US treasury bonds since US treasuries are taxable. However, based on your tax-bracket, the tax-free municipal bond with a lower yield may offer you a higher after-tax return than the higher-yielding taxable US treasury bonds. Therefore, it is important to know how to compare a tax-exempt (tax-free) bond with a taxable bond.
For instance, let’s say you are in the 35% tax-bracket on the federal level. This means that on every additional dollar of income you generate, you will pay 35 cents in taxes. You are considering $5,000 to be invested in 1 of the 2 options, both maturing in 2015:
Option 1: A tax-exempt California municipal bond yielding 2.4%
Option 2: CD yielding 3%
With the CD, the yield you are receiving will be taxable at 35%. With the municipal bond, the yield is tax-free. To compare the 2 options, you need to figure out the taxable-equivalent yield of the municipal bond.
Calculating The Taxable-Equivalent Yield
First figure out what you keep from taxable investments, which is 65% or .65 of the taxable yield. Since you pay 35% of every dollar in taxes, you get to keep 65%.
1 (your tax bracket of 35%) = .65
Next, take the tax-exempt yield of 2.4% and divide it by .65.
2.4 divided by .65 = 3.6923%
3.7% (rounded up from 3.6923) is the taxable-equivalent yield of 2.4% California municipal bond if you are in the 35% tax bracket. Obviously, this is more than the CD’s taxable rate of 3%. Another way of saying this is that if you were to earn 3.7% and pay 35% on the interest, you would end up with 2.4% after-tax yield. Therefore, an investor in the 35% tax bracket would choose Option 1, since the higher taxable-equivalent yield would generate a more appealing income stream.
This concept is so important that it warrants another example:
Now, let’s say you are retired and find yourself in the 15% tax bracket.
Option 1: Municipal bond with 2.4% tax-free yield
Option 2: CD with 3% yield
Step 1: First, figure out how much you keep after taxes.
Using the formula, you would keep 1 – .15 = .85, or 85% of your income after taxes.
Step 2: Figure out how much 2.4% is in taxable-equivalent terms.
2.4 divided by .85 = 2.82%
2.82%: That is the taxable-equivalent yield of 2.4% if you are in the 15% federal tax-bracket. This is less than the 3% you could yield with the CD. Plus, the CD is federally insured.
These two examples show how your tax bracket is very important in figuring out what’s right for you. If you were in the 35% tax bracket, the taxable-equivalent yield of 2.4% tax-free is 3.7%; if you are in the 15% tax bracket, 2.4% tax-free equals 2.82% pre-tax.
Below is a handy chart that will show you the taxable-equivalent yields. The row on top is the tax-free yield. The first column is the tax bracket. Based on the tax-bracket, look at the corresponding taxable-equivalent yield.
Taxable-equivalent yield chart:
You should now be comfortable with the concept of how your tax bracket impacts your actual return from tax-free municipal bonds. So far, we have covered federal taxes since all tax-exempt municipal bonds are free of federal taxes. Next, we’ll cover state taxation issues.
There are certain types of bonds where the interest is subject to AMT or alternative minimum taxes. Most are not, but a few are.
There are such things as taxable’ municipal bonds. These bonds will be clearly marked. If the yield looks a little too high, make sure it is not taxable.