Municipal bonds tend to fit a specific type of investor. Like other bonds, they’re often used to generate income. The key difference is taxes: many municipal bond interest payments are exempt from certain taxes, so municipal bonds usually offer lower interest rates and yields than comparable taxable bonds.
To justify buying a lower-yielding municipal bond, the investor typically needs to be in a high tax bracket. In a progressive tax system, higher income generally means a higher tax bracket. If you’re not paying much in taxes, the tax benefit of a municipal bond may not be large enough to make up for its lower yield.
Investors in high tax brackets can still earn competitive after-tax returns with municipal bonds. Let’s walk through an example:
A wealthy investor at the 37% tax bracket is considering a corporate bond yielding 7% or a municipal bond yielding 5%.
At first glance, the corporate bond looks better because 7% is higher than 5%. But the corporate bond’s interest is fully taxable, while the municipal bond’s interest is tax-free (assuming the investor is a resident). To compare them fairly, we calculate the corporate bond’s after-tax yield using the tax-free equivalent yield formula:
Your guide:
After taxes, the corporate bond provides an effective yield of 4.4%, which is below the municipal bond’s 5% tax-free yield. In this situation, the municipal bond is the better choice - but that result depends on the investor’s high tax bracket. What happens if the tax bracket is lower?
An investor at 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?
With a 25% tax bracket, the corporate bond’s after-tax yield is 5.25%, which is higher than the municipal bond’s 5% tax-free yield. So, even a modest drop in tax bracket can make the taxable corporate bond the better investment. Ultimately, municipal bonds are only suitable for those at high tax brackets.
We haven’t learned about them yet, but municipal bonds are also generally 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 often avoid municipal bonds in retirement accounts because the account already provides a tax shelter. In other words, there’s little reason to accept a lower municipal yield for a tax benefit you don’t need inside the account. Instead, you could buy a higher-yielding corporate or US Government bond (normally taxable) and still avoid current taxes because the retirement account shelters the income.
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