With yields on the safest fixed-income investments still very low, one way to boost your bottom line is to shield that income from further erosion.
Interest income that is sheltered from federal taxation—and possibly state and local taxes as well—has always been the main attraction of municipal bonds.
However, tax-advantaged bonds generally offer a lower coupon rate than taxable bonds of similar maturity, such as government bonds.
How do you compare the yields of bonds that receive different tax treatments?
A relatively simple formula can help you put the yields on an equal footing.
The first factor in the equation is your marginal tax rate.
Your marginal tax rate is the percentage tax rate that you pay on your last dollar of taxable income; it is typically higher than or equal to your average tax rate. If you are in the higher tax brackets and subject to phaseout rules that reduce itemized deductions and personal exemptions, your real marginal rate may be a percentage or two higher than the stated percentage bracket.
While interest earned on municipal bonds is generally exempt from federal income tax, exemption of the interest from state income taxes is not uniform. You need to become familiar with the tax-exemption rules of your own state, particularly the tax-exempt status of others states’ bonds, if you want to take state and local taxes into consideration.
Keep in mind that, although interest income may be exempt from federal, state, and/or local taxes, capital gains and losses are generally taxable at all levels.
Assuming that the tax-exempt and fully taxable investment alternatives have similar maturities, then a simple calculation tells you the taxable equivalent yield of the tax-exempt bond:
When using this formula to obtain the taxable-equivalent yield, you should convert percentages to decimals—for example, if you are in the 35% marginal federal tax bracket (0.35 in decimal form) and you are considering the purchase of a municipal bond with a 3.33% (0.033 in decimal form) yield that is exempt from federal taxes, your calculation looks like this:
This tells you that in your tax bracket (35%), a municipal bond yield of 3.33% is equivalent to a taxable bond that has a yield of 5.08%.
If you were in the 15% tax bracket, on the other hand, the same formula would result in a tax-equivalent yield of 3.88%. This changes the picture considerably.
You can use the same formula to determine whether an in-state bond, on which you pay no state tax, would net you more than an out-of-state bond on which you would have to pay state taxes. For example, if your state tax is 5%, add that amount to your federal tax (35% in the preceding example) and substitute the resulting number (40%) in the above formula. And you can use it to compare yields on municipal bond mutual funds and exchange-traded funds with similar maturity taxable funds.
Table 1 provides the taxable equivalent yields of tax-exempt yields ranging from 1% to 6% for the current federal income tax brackets.
|If The Tax-Exempt Yield Is:|
|The Taxable Equivalent Yield (%) Is:|
Note that your tax bracket is not the only factor to consider when comparing taxable and tax-exempt yields. You need to compare fixed-income instruments that are comparable in credit quality and maturity length. In the world of bonds, you can always get a higher yield by taking on more risk. That could be interest rate risk (buying bonds with longer maturities) or credit risk (buying bonds with lower credit quality).
That does not mean you should not be taking on higher risk, but rather that you need to understand the risk you are taking and be comfortable with it. It also means that you should be compensated adequately for the additional risk. But when comparing bond yields, the first step is to start by comparing bonds whose risk profiles are similar.
As a general rule, taxpayers in the highest tax brackets benefit from buying tax-exempt bonds, while those in the lowest do not. But for those in the middle, the relative attractiveness of munis over taxables varies, due to changes in tax laws, changes in the demand for municipal bonds over time, and changes in the yield curve [the graph of yields at different maturities for bonds of the same credit quality].
For example, in the early 1990s, the yield of high-quality munis with long-term maturities of 20 to 30 years was typically between 80% and 85% of the yields of Treasuries with comparable maturities. More recently, long-term munis have been yielding as much as 95% of Treasuries of comparable maturity.
Table 2 shows the current yield of high-quality municipal bonds over a variety of maturities, and how they compare to the current yield of U.S. Treasuries of comparable maturity. You can see that even within the current range of maturities, the yield advantage of municipals relative to Treasuries is not constant.
|Maturity (No. of Years)|
|U.S. Treasuries (%)||0.50||2.75||3.72||4.45||4.45|
|Munis Relative to Treasuries (%)||84.0||80.0||89.2||97.3||105.6|
|Taxable Equivalent Yield of Munis|
|35% Tax Bracket (%)||0.6||3.4||5.1||6.7||7.2|
|28% Tax Bracket (%)||0.6||3.1||4.6||6.0||6.5|
|15% Tax Bracket (%)||0.5||2.6||3.9||5.1||5.5|
|* General obligation AAA municipals, as reported by Standard & Poor’s.|
|Sources: U.S. Treasury Dept. (as of 6/22/09) and Investinginbonds.com (as of 6/22/09).|
Currently, the spread in yields between municipals and Treasuries is extremely tight in large part due to the recent economic crisis and the high demand by many investors for the safe harbor of Treasury securities.
Treasuries are considered to be virtually risk free in terms of default risk. Municipals do have default risk, although for high-quality municipals that risk has in the past been low. Municipals also have the risk that their credit quality rating may change over time; a drop in their rating would cause the municipal’s existing bonds to drop in value.
The taxable equivalent yield calculation does not take into consideration two tax complications you should be aware of when investing in municipals.
One of the complicating factors is the alternative minimum tax, which originally was devised to ensure that all individuals with income would pay a reasonable tax rate, but which is ensnaring more and more taxpayers each year.
To determine the alternative minimum tax, certain preference items are added back to regular taxable income; individuals are subject to the AMT if total taxes due using this method would be higher than the taxes due under the regular income tax.
Interest income on certain private-activity municipal bonds is categorized as a preference item in determining the alternative minimum tax, even though it is exempt from the regular federal income tax.
On the other hand, bonds with interest subject to the AMT do tend to carry higher yields, offering some compensation for individuals pushed into the alternative minimum tax.
Another complicating factor involves Social Security. For retirees receiving Social Security payments, tax-exempt bond interest can trigger additional federal tax payments on your Social Security benefits. If the sum of your adjusted gross income plus your tax-exempt bond interest plus half of your Social Security payments exceeds $25,000 for single persons or $32,000 for couples filing joint returns, then some of your Social Security benefits are taxed. [You should consult the IRS for more details.]
While alternative minimum tax and Social Security tax considerations may diminish the aftertax benefits of tax-exempt interest income, from the taxable equivalent yield calculations it is clear that high-tax-bracket individual investors should consider investing the fixed-income portion of their portfolio in tax-exempt bonds.
If, however, given your tax bracket and current interest rates, you can get higher yields from taxable securities, then municipal bonds do not make sense.
But to determine whether tax-exempts are worth it, you must do the calculation.
It always pays to do the math.