Municipal bonds offer investors interest payments that are exempt from federal income taxes, and (for residents of that state) generally exempt from the taxes of the state and/or city in which the bonds are issued. (Income on certain bonds for particular investors, however, may be subject to the federal alternative minimum tax.) While interest income is generally tax-free, capital gains, if any, are subject to taxes.
In addition, some municipal bonds have their principal and interest payments guaranteed by an insurance company, adding an extra layer of protection in the event of default. The insurance does not guarantee the original price if sold prior to maturity, or current market value.
Municipal bonds are debt obligations of states, cities, towns, municipalities, municipal authorities, and governmental entities. They are typically issued to raise funds to build public facilities, such as schools, courthouses, and libraries, or to finance infrastructure improvements, such as bridges, airports, roads, tunnels, and water and sewer systems.
Consider municipal bonds if your tax bracket makes it desirable to seek tax-exempt income. To determine whether municipal bonds may provide you with significant tax savings, you need to calculate the taxable equivalent yield. This is the yield a taxable investment would need to pay in order to match the tax-free return offered on a municipal bond.
Suppose, for example, that you are a single taxpayer who is considering investing in a bond. Your choices are between a tax-free municipal bond with a 5% coupon, and a corporate bond that is fully taxable and pays 7.5% interest a year. The bonds have similar credit ratings and maturities. How can you decide which bond is best for you?
A simple equation will help you compare the tax-free yield of a municipal bond to the yield of a taxable bond. The first step is to determine your federal income tax bracket.
| Single Individuals |
| 2012 |
| If taxable income is: |
Pay |
+ |
% on Excess |
of the amount over |
| $0 to $8,700 |
$0 |
|
10% |
$0 |
| $8,700 to $35,350 |
$870 |
|
15% |
$8,700 |
| $35,350 to $85,650 |
$4,867.50 |
|
25% |
$35,350 |
| $85,650 to $178,650 |
$17,442.50 |
|
28% |
$85,650 |
| $178,650 to $388,350 |
$43,482.50 |
|
33% |
$178,650 |
| $388,350 and over |
$112,683.50 |
|
35% |
$388,350 |
|
| Married Filing Jointly (and Surviving Spouses) |
| 2012 |
| If taxable income is: |
Pay |
+ |
% on Excess |
of the amount over |
| $0 to $17,400 |
$0 |
|
10% |
$0 |
| $17,400 to $70,700 |
$1,740 |
|
15% |
$17,400 |
| $70,700to $142,700 |
$9,735.00 |
|
25% |
$70,700 |
| $142,700 to $217,450 |
$27,735.00 |
|
28% |
$142,700 |
| $217,450 to $388,350 |
$48,665.00 |
|
33% |
$217,450 |
| $388,350 and over |
$105,062.00 |
|
35% |
$388,350 |
|
| Married Individuals Filing Separately |
| 2012 |
| If taxable income is: |
Pay |
+ |
% on Excess |
of the amount over |
| 0 to $8,700 |
$0 |
|
10% |
$0 |
| $8,700 to $35,350 |
$870 |
|
15% |
$8,700 |
| $35,350 to $71,350 |
$4,867.50 |
|
25% |
$35,350 |
| $71,350 to $108,725 |
$13,867.50 |
|
28% |
$71,350 |
| $108,725 to $194,175 |
$24,332.50 |
|
33% |
$108,725 |
| $194,175 and over |
$52,531.00 |
|
35% |
$194,175 |
|
| Head of Household |
| 2012 |
| If taxable income is: |
Pay |
+ |
% on Excess |
of the amount over |
| 0 to $12,400 |
$0 |
|
10% |
$0 |
| $12,400 to $47,350 |
$1,240.00 |
|
15% |
$12,400 |
| $47,350 to $122,300 |
$6,482.50 |
|
25% |
$47,350 |
| $122,300 to $198,050 |
$25,220.00 |
|
28% |
$122,300 |
| $198,050 to $388,350 |
$46,430.00 |
|
33% |
$388,350 |
| $388,350 and over |
$109,229.00 |
|
35% |
$388,350 |
|
| Estates and Trusts |
| 2012 |
| If taxable income is: |
Pay |
+ |
% on Excess |
of the amount over |
| 0 to $2,400 |
$0 |
|
15% |
$0 |
| $2,400 to $5,600 |
$360 |
|
25% |
$2,400 |
| $5,600 to $8,500 |
$1,160 |
|
28% |
$5,600 |
| $8,500 to $11,650 |
$1,972 |
|
33% |
$8,500 |
| $11,650 and over |
$3,011.50 |
|
35% |
$11,650 |
|
Then, plug the yield of the municipal bond into this formula:
Tax-Free Municipal Bond Yield / (1 - your Federal Tax Bracket) = Taxable Equivalent Yield
Using the above example, the tax-free yield of the municipal bond is 5%. Suppose that your earnings place you in the 35% tax bracket. At 35% (or .35), the equation would look like this:
5% Annual Yield / (1 - 35%) or 5% / 0.65 = 7.69% Taxable Equivalent Yield
In this case, your taxable equivalent yield is 7.69%. This means that you would have to find a taxable investment that yields more than 7.69% per year so that, after taxes, it would be higher than the tax-free yield of the 5% bond. (State or local taxes could be another factor for consideration.) Please note that this is a hypothetical example for illustrative purposes only, and should not be considered indicative of any specific investment. By using the taxable equivalent yield formula, you can better determine which investments-taxable or tax-exempt-would yield more for you.
