As an investor, you have multiple choices for fixed-income investments. With various alternatives choices available, why choose municipal bonds?
There are several good reasons to consider bonds – the primary being reliable tax exempt income.A second good reason is municipal bonds are second in safety only to U.S. Treasury securities. Choice of maturity and liquidity are additional reasons.
Tax Advantages of Municipal Bonds
The vast majority of municipal bonds are tax-free, meaning that the interest income is exempt from federal income taxes.
Tax-free income is advantageous regardless of your tax bracket, but it is even more valuable to “High Net Worth” individuals who qualify for the highest tax brackets. A simple way to estimate the amount of benefit you receive from tax-free municipal bonds is to determine a taxable equivalent yield – in essence, the yield on a taxable bond that you would have to receive to match the yield of a particular tax-free bond.
To find your taxable equivalent yield, determine (or estimate) your tax bracket for the upcoming filing period. Express the tax percentage as a decimal, and subtract it from one. Divide the yield of a particular tax-free bond by that number, and the result is the equivalent rate in taxable bonds.
For example, let’s assume you are considering a tax-free municipal bond with 3% yield. If you fall into the 35% tax bracket, the taxable equivalent yield would be 3% divided by 0.65. That answer is 4.62% – meaning that you would have to receive anestimated yield of 4.62% on an equivalent taxable bond to receive the same level of benefit as a tax-free bond with 3% yield. For the highest current tax bracket of 39.6%, that value becomes 4.97%.
In some cases, municipal bonds may be triple-tax-free – providing further benefits through exemption from federal, state and local taxes. Usually the bonds of an issuing state or municipality are exempt from local taxes as well.
Should you find local bonds issued in your area meet your investment needs, you may be able to receive multiple tax benefits while feeling the sense of civic pride that follows from investing in your community.
Different states have different rules with regard to taxation of municipal bonds, so it is important that your broker know the rules relevant to your state and city.
Taxable Municipal Bonds
Taxable municipal bonds have been growing in popularity in recent years. They are typically issued for non-essential service projects like replenishing underfunded pension programs, or projects such as local sports stadiums and housing developments where the benefits to the general publicdo not warrant federal government-subsidized financing.
These bonds are generally purchased by institutional investors and by individuals for their retirement account. Taxable municipal bonds offer higher yields to compensate for their taxable status. In this case you will need to evaluate the yield versus the combined effect of taxation and the degree of risk underlying the bonds. Although municipal bonds are typically low-risk, they are not entirely risk-free.
Municipal bonds can provide a steady stream of tax-free income with a relatively high degree of security. They also offer a wide variety of issuers to choose from – similar to corporate bonds in that respect, but including tax-exemption. They are available with different terms, yields, and associated risks, making it relatively easy to find a match for the available slots in the fixed-income segment of your investment portfolio.
Why buy municipal bonds? Perhaps the better question is – why not buy municipal bonds?