Municipal bonds can be a good fit for a specific type of investor. Like any bond, they’re often purchased for income. What makes municipal bonds different is their tax advantage. Because the interest is generally exempt from federal income tax (and may also be exempt from state and local taxes for in-state residents), municipal bonds usually offer lower interest rates and yields than comparable taxable bonds.
That trade-off only makes sense if you’re in a high tax bracket. With a progressive tax system, higher levels of taxable income are taxed at higher rates. So, you’ll typically consider a lower-yielding municipal bond only when the tax savings make up for the lower stated 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 in the 37% tax bracket is considering a corporate bond yielding 7% or a municipal bond yielding 5%.
At first glance, the corporate bond’s 7% yield looks better. 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, calculate the corporate bond’s after-tax yield using the tax-free equivalent yield:
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 only because the investor is in a high tax bracket.
What if the tax bracket is 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?
Here, the corporate bond’s after-tax yield is 5.25%, which is higher than the municipal bond’s 5% tax-free yield. A lower tax bracket changes the comparison, making the corporate bond the better investment.
Ultimately, municipal bonds are only suitable for those in high tax brackets.
We haven’t covered retirement plans in detail 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 held in the account, the investor generally doesn’t pay taxes on investment returns while the money remains in the account. Taxes are typically paid when the account owner withdraws money in retirement.
Because retirement accounts already provide a tax shelter, municipal bonds usually don’t add much value there. Why buy a low-yielding, tax-free bond inside a tax-sheltered account? Instead, an investor could hold a higher-yielding corporate or U.S. government bond (both normally taxable) and still avoid current taxes because the retirement account shelters the income.
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