Are Tax-Saving Municipal Bonds Right for You?

Municipal bonds and bond funds – both of which offer the potential for tax-free income – have long been popular among investors in higher tax brackets.

But are they an appropriate investment for you?

Municipal bonds are issued by state and local governments. They’re used to finance public projects and certain types of private projects.

Municipal bonds are tax exempt

Traditionally, investors have purchased municipal bonds because the interest on them is exempt from federal taxes and may also be exempt from state and local taxes.

For example, a resident of California likely won’t pay state or local taxes on a state of California bond.

The actual yield on a municipal bond may be lower than on a taxable investment. However, you want to consider the “tax equivalent yield,” which is the yield of a municipal bond after you’ve considered the fact that you aren’t taxed on the bond’s interest. You may find that its tax-equivalent yield is actually higher than the yield on a taxable investment.

Consider tax-equivalent yield

To determine this you’ll need to calculate a municipal bond’s tax-equivalent yield. First, obtain the yield of the municipal bond or bond fund you are considering. Then, determine your tax bracket. Finally, divide the yield of the municipal bond or bond fund by 100% minus your tax bracket.

For example, suppose you are in the 30% tax bracket. You currently own a corporate bond yielding 8%, and you want to know whether a municipal bond or bond fund yielding 6% is a better investment.

If you divide the yield of the municipal bond (6%) by 100% minus 30% (70%), you’ll get a tax-equivalent yield of 8.6%.

In this case, the tax-equivalent yield of the municipal bond or bond fund is more than the yield of the corporate bond, so the municipal bond might be a better investment for you.