How would you like an investment that pays interest but where you never have to pay taxes on the income? That’s the attraction of municipal bonds.
Municipal bonds, usually referred to as “munis” are issued by state and local governments and the interest they pay is not subject to federal income tax. Certain bonds are also not taxed at the state level – these are called double tax-exempt.
So what’s the catch? The most obvious is that munis usually pay lower interest rates than taxable bonds of similar maturity and quality.
Whenevaluatingwhethermunis make sense for you, you need to look at what you could earn on taxable bonds of similar quality and maturity, then subtract out the taxes you would have to pay. For example, if a taxable bond is yielding 6% and you are in the 25% marginal tax bracket, your net after-tax yield would be 4.5%. If a similar muni bond yields more than that it could be a better investment. Depending on the particular bond you may also need to take state income taxes into consideration.
You may see reference to a so-called tax-equivalent yield when looking at muni-bond or bond-fund information. That’s the rate that a taxable bond or fund would have to pay to equal the muni on an after-tax basis. The formula is simple:
Beware, however, that when the tax-equivalent rate is quoted for a tax-free investment it is usually calculated for an investor in the highest marginal tax bracket, currently 35%. So while it may make sense for a wealthy investor, you will need to do your own calculation if you are in a lower tax bracket.