If you sell a municipal bond at a profit, you could incur capital gains taxes. Also, the principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. And remember that municipal bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund's performance.
Weighing the Choice between Taxable and Tax-Free Bonds
If you're considering the purchase of an individual bond or
even a bond mutual fund, one of your first concerns will be its yield. However,
when comparing various yields, you need to make sure you're not comparing
apples to oranges. The yield on a tax-free bond may be lower than that paid by
a taxable bond, but you'll need to look at its tax-equivalent yield to compare
What's taxable? What's not?
The interest on corporate bonds is taxable by local, state,
and federal governments. However, interest on bonds issued by state and local
governments (generically called municipal bonds, or munis) generally is exempt
from federal income tax. If you live in the state in which a specific muni is
issued, it may be tax free at the state or local level as well.
Unlike munis, the income from Treasury securities, which are
issued by the U.S. government, is exempt from state and local taxes but not
from federal taxes. The general principle is that federal and state/local
governments can impose taxes on their own level, but not at the other level;
for example, states can tax securities of other states but not those of the
federal government, and vice versa.
The impact of freedom from taxes
In order to attract investors, taxable bonds typically pay a
higher interest rate than tax-exempt bonds. Why? Because of governmental
bodies' taxing authority, investors often consider munis safer than corporate
bonds and are more likely to accept a lower yield. Even more important is the
associated tax exemption, which can account for a difference of several
percentage points between a corporate bond's coupon rate — the annual percentage
rate it pays bondholders — and that of a muni with an identical maturity period.
Still, depending on your tax bracket, a tax-free bond could
actually provide a better net after-tax return. Generally, the higher your tax
bracket, the higher the tax-equivalent yield of a muni bond will be.
It's not what you get, it's what you keep
To accurately evaluate how a tax-free bond compares to a
taxable bond, you'll need to look at its tax-equivalent yield. To do that, you
apply a simple formula that involves your federal marginal tax rate — the income
tax rate you pay on the last dollar of your yearly income. The formula depends
on whether you want to know the taxable equivalent of a tax-free bond, or the
tax-free equivalent of a taxable bond. The table on the next page shows the
tax-free equivalents of various taxable yields; the figures are determined by
subtracting your marginal tax rate from 1, then multiplying the taxable bond's
yield by the result. To calculate the taxable equivalent of a tax-free yield, subtract your marginal tax rate from 1, then divide the tax-free yield by the result.
If a taxable bond also is subject to state and local taxes
and the tax-exempt one isn't, the tax-exempt bond's coupon rate could be even
lower and still provide a higher tax-equivalent yield.
Munis are tax free, except when they're not
As is true of almost anything that's related to taxes, munis
can get complicated. A bond's tax-exempt status applies only to the interest
paid on the bond; any increases in the bond's value are taxable if and when the
bond is sold. You also may owe taxes when you sell shares of a muni bond mutual
Also, specific munis may be subject to federal income
tax, depending on how the issuer will use the proceeds. If a bond finances
a project that offers a substantial benefit to private interests, it is taxable
at the federal level unless specifically exempted. For example, a
new football stadium may serve a public purpose locally but provide little
benefit to federal taxpayers. As a result, a muni bond that finances it is
considered a so-called private-purpose bond. Other public projects
whose bonds may be federally taxable include housing, student loans, industrial
development, and airports.
Even though such bonds are subject to federal tax, they
still can have some advantages. For example, they may be exempt from state or
local taxes. And you may find that yields on such taxable municipal bonds are
closer to those of corporate bonds than they are to tax-free bonds.
Agencies and GSEs (government-sponsored enterprises) vary in
their tax status. Interest paid by Ginnie Mae, Fannie Mae, and Freddie Mac
is taxable at federal, state, and local levels. The bonds of other
GSEs, such as the Federal Farm Credit Banks, Federal Home Loan Banks, and the
Resolution Funding Corp. (REFCO), are subject to federal tax but exempt from
state and local taxes. Before buying an agency bond, verify the issuer's tax
Don't forget the AMT
To even further complicate matters, the interest from
private-purpose bonds may be specifically exempted from regular federal income
tax, but still may be considered when calculating whether the alternative
minimum tax (AMT) applies to you. A
tax professional can determine the likelihood that a bond will affect
your AMT liability.
|Taxable Yield (%)||Equivalent Tax-Free Yield (%)|
Tip: The equivalent tax-free yield can be even lower if you are subject to an additional 3.8% Medicare contribution tax that applies to net investment income for individuals with an adjusted gross income of more than $200,000 ($250,000 for married couples filing jointly).
Pay attention to muni bond funds
Just because you've invested in a municipal bond fund
doesn't mean the income you receive is automatically tax free. Some muni funds
invest in both public-purpose and private-purpose munis. Those that do must
disclose on their yearly 1099 forms how much of the tax-free interest they pay
is subject to AMT.
Before investing in a
mutual fund, carefully consider its investment objectives, risks,
fees, and expenses, which are in
the prospectus available from the fund;
carefully before investing.
Use your tax advantage where it counts
Be careful not to make a mistake that is common among people
who invest through a tax-deferred account, such as an IRA. Because those
accounts automatically provide a tax advantage, you receive no additional
benefit by investing in tax-free bonds within them. By doing so, you may be
needlessly forgoing a higher yield from a taxable bond. Tax-free munis are best
held in taxable accounts.