Everybody wants tax-free income and a municipal bond is a common strategy utilized by many investors to do just that. But, how do you know if municipal bonds make sense for you? Understanding how municipal bonds are taxed and comparing the effective after-tax yield from a comparable taxable bond are two important factors.
Municipal bond income is tax-free for Federal income taxes purposes, but may not be tax-free for state income tax. Make sure you check your state tax laws before jumping in. It is also important to remember that if and when you sell the municipal bond in the future, the gains earned on the sale are still subject to capital gains tax treatment, like other taxable bonds.
After-tax Yield. The effective after-tax yield allows the investor to compare the municipal bond with the taxable bond for an apples to apples comparison. Essentially, the taxable bond yield is translated into an after-tax yield so the investor can compare the two options. Once you have an idea of the expected yield on the taxable bond, you can use your marginal Federal tax bracket to determine the effective after-tax yield. The marginal bracket is the highest tax rate applied against your bond income.
Effective after-tax yield = Expected yield – (Expected yield * Marginal Federal tax rate)
For example, assume a taxable bond is yielding 5% and the marginal Federal tax rate for the investor is 39.6%. The after-tax return on the taxable bond equals 3.02%. This means if an investor can obtain a muni-bond yielding more than 3.02% tax-free with comparable amount of risk, the investor would be better off with the muni-bond.
For an investor in the 15% marginal Federal tax bracket, the after-tax yield on the same taxable bond would be 4.25%. This means if an investor can obtain a muni-bond for more than 4.25% tax-free with similar amount of risk, the investor would be better off with the muni-bond. But, notice how the after-tax yield for this investor in the lower tax bracket is much higher than the investor in the higher tax bracket. This example illustrates how a municipal bond may not be the best option for an investor in lower tax brackets.
Other Tax Considerations. High-income investors who are also subject to the 3.8% net investment income tax surcharge have even more reason to take a look at municipal bonds. Moving taxable investment income into tax-free muni-bonds would avoid this relatively new and painful tax. Muni-bonds may also help taxpayers stay below phase-out thresholds for certain exemptions and deductions. With that being said, some types of municipal bonds can trigger AMT (Alternative Minimum Tax) issues and eliminate the tax benefits altogether.
There are many opportunities with municipal bonds, but also potential pitfalls that you must be aware of. Talk it over with your tax advisor, who can help you evaluate municipal bonds relative to other options on an after-tax basis. That really is the best way to determine whether or not the tax benefits outweigh the possible lower return associated with municipal bonds.
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