Municipal bonds can be very attractive to investors because of their beneficial tax treatment. This is a major benefit to investors since non-taxable bonds are tax exempt regardless of the investor’s tax bracket. Below we outline four key tax treatments of municipal bonds.
In bond investing, municipal bonds are known for being tax free, which makes them very attractive to investors. Unlike most investments, which require a tax to be paid on earnings, most municipal bonds are tax exempt to most investors.
Sold to help finance special projects, a municipal bond is eligible to be tax exempt for businesses, including manufacturing companies and non-profit organizations. These organizations are permitted to sell tax-exempt bonds of up to $10 million dollars to fulfill all or some of their financial requirements. Bonds are not eligible for tax exemption if they finance debt relief or venture and working capital.
For each specific bond, an official statement is issued that states the terms of the bond. Along with describing the terms, such as explaining when the bond can be redeemed and the benefits to the bondholder, the statement also explains the exact terms of the tax-free or taxable bond.
When comparing tax-exempt bonds with taxable bonds, investors look at the tax-equivalent yield. This yield effectively compares the two bonds to see which bond would be the better investment. The tax equivalent yield is equal to the bond’s tax-free municipal bond yield divided by one minus its tax rate.
Although most municipal bonds are tax exempt, there are some bonds that are an exception to the rule and are subject to taxation. In some cases, the government will not subsidize the funding of a certain project if they don’t believe the project will make a significant improvement benefiting the general public. These cases–for example, investor-led housing, local sports facilities or other private projects–require bondholders to pay tax on the interest that they earn. Overall, the number of taxable bonds has been increasing over the past few years.
Alternative minimum tax (AMT) is a system that the IRS uses in order to ensure that the minimum amount of the tax is always paid by investors. The system makes sure that investors pay their fair share of tax even after any deductions, credits or exemptions.
This system has become very controversial as it targets middle- and upper-class investors. Many investors are unhappy with AMT since they feel that the tax is unfair to those having children or living in high-tax states.
These bonds are issued as “private activity bonds,” which are bonds used for private investment for projects that have some public benefit. This bond is often used since it cuts financing costs by avoiding federal tax.
State Tax Treatment
Depending on the particular state, income tax from bonds may or may not be subject to taxation. Individuals who are residents of Texas, Washington State, Florida, Nevada, Alaska, Wyoming, Texas or South Dakota are not required to pay income tax on their bond interest. Therefore, investors from the aforementioned states are able to purchase bonds from any state and not pay state taxes on them.
Residents from the states that do not have state income tax are often indifferent to whether or not they are buying bonds from their state or another state. However, bonds from states with no income tax requirements tend to have higher yields to attract local residents into buying them. Local residents may not be interested in local bonds if they do not offer a high yield since they receive the same tax exemption benefit locally and country-wide.
In 2008, a U.S. Supreme Court case was brought up against Kentucky (Kentucky vs. Davis), accusing the state of discriminating against interstate commerce by making state-issued bonds tax exempt, while taxing bonds issued in other states. The case against the state was unsuccessful with a vote of 7-2.
In most states, only interest from bonds that were issued in that state are exempt from taxes. Bonds issued from other states may be taxed.
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 U.S. treasury bonds since U.S. 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 U.S. treasury bond. 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 investing $5,000 in one of the following two 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 two 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 the 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:
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.
Taxable-Equivalent Yield for Different Tax Brackets
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.
The Bottom Line
Municipal bonds obviously come with the distinct advantage of being non-taxable, but before investing, thorough research should be done on the asset class as a whole. It is important for investors to make comparisons between taxable bonds and municipal bonds both on a qualitative and quantitative basis including calculating the taxable-equivalent yield.
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.