Tax implications

It’s important to know how the income from debt securities is taxed. Various tax implications exist, depending on the type of issuer.

Corporate bonds

Interest paid by corporate bonds is fully taxable as ordinary income, making investors subject to federal, state, and local taxes. Federal taxes on ordinary income depend on the investor’s marginal tax bracket, which could be up to 37%. Some states and cities impose their own income taxes, while some do not. If this information is important in a test question, it will be provided.

US Government bonds

Interest paid by US Government bonds is subject to federal taxes, but exempt from state and local taxes. Because federal taxes tend to be the biggest taxes a citizen pays, investors typically only save a bit of money by not paying state or local taxes. The amount of “savings” depends on the state. For example, high-income earners in Hawaii are subject to a 16% state income tax, while the state of Washington does not have an income tax.

Municipal bonds

Interest paid by municipal bonds is exempt from federal taxes, but subject to state and local taxes. Regardless, most investors won’t pay any taxes on municipal bond interest. As long as the investor is a resident of the state they purchase the bond from, they avoid all taxes (including state and local taxes). For example, a California municipal bond pays tax-free interest to any investor with residency in California. However, if a resident of Colorado purchases a municipal bond from California, the investor may be subject to state and local taxation. This depends on the state and city, and whether or not an income tax is assessed. Bottom line - state residents do not pay interest taxes on municipal bonds from their state.

An exception to the residence tax rule exists with US territory bonds, which are also considered municipal bonds. The US territories are:

• American Samoa
• Guam
• The Northern Mariana Islands
• Puerto Rico
• The US Virgin Islands

Regardless of residence, these bonds are always tax-free to the investor. For example, residents of Alaska that purchase US Virgin Islands bonds receive all interest fully tax-free.

Municipal bonds are suitable for a very specific type of investor. Just like any other bond, investors seek income from municipal bonds. However, a unique factor influences the suitability of these bonds. Due to their tax benefits, municipal bonds have low interest rates and yields.

In order to justify the investment, an investor must be in a high tax bracket. With our progressive tax system, Americans have higher tax brackets when they have more reportable income. Investors shouldn’t consider a low-yielding municipal bond with tax benefits if the tax benefits aren’t worth it.

Investors in high tax brackets can obtain reasonable returns from municipal bonds. Let’s look at the following example:

A wealthy investor in the 37% tax bracket is considering a corporate bond yielding 7% or a municipal bond yielding 5%.

On the surface, the corporate bond seems better. However, the corporate bond is fully taxable and the municipal bond is tax-free (assuming the investor is a resident). To find the after-tax return of the corporate bond, you could do the tax-free equivalent yield formula:

$\text{TFEY}=\text{CY\hspace{0.33em}x (100\% -TB)}$

$\text{TFEY}=\text{7\% x (100\% -37\%)}$

$\text{TFEY}=\text{7\% x\hspace{0.33em}63\%}$

$\text{TFEY}=\text{4.4\%}$

Your guide:

$\text{TFEY}=\text{tax-free\hspace{0.33em}equivalent yield}$

$\text{CY}=\text{corporate\hspace{0.33em}yield}$

$\text{TB}=\text{tax\hspace{0.33em}bracket}$

When we remove the taxes from the corporate bond, we find it’s only providing an after-tax yield of 4.4%, which is below the 5% tax-free yield of the municipal bond. In this situation, the municipal bond is better for the investor, but only because of their high tax bracket. What if the tax bracket was lower?

An investor in the 25% tax bracket is considering a corporate bond yielding 7% or a municipal bond yielding 5%. What is the tax-free equivalent yield of the corporate bond?

Can you figure it out?

As you can see, just a slight downturn in the investor’s tax bracket made the corporate bond a better investment. The after-tax yield of the corporate bond is better than the tax-free return of the municipal bond. Ultimately, municipal bonds are only suitable for those in high tax brackets.

We haven’t learned about them yet, but municipal bonds are also unsuitable for retirement plans. Retirement plans, like individual retirement accounts (IRAs), are tax-sheltered investment accounts. No matter what type of investment is in the account, the investor does not pay taxes at the time they make a return on their investments. Taxes are generally paid when the account owner pulls money out of the account in retirement.

Investors avoid municipal bonds in retirement accounts because of the tax shelter they provide. Why purchase a low-yielding, tax-free bond in a tax-sheltered account? You could purchase a higher-yielding corporate or US Government bond, both of which are normally taxable, and avoid the taxes in your retirement account.