Content
- What Are Municipal Bonds?
- An Investment For Today's Tax-conscious Investor
- The Advantages of Tax Exemption
- Understanding Yields
- How Safe Are Municipal Bonds?
- Understanding Market Risk
- Understanding Calls
- Gains and Losses
- Bonds With Special Investment Features
- Types of Tax-exempt Municipal Bonds
- Taxable Municipal Bonds
- Other Basic Facts
- The Tax-exempt Municipal Bond Market--How Big and Who Buys?
- Tax-exempt/Taxable Yield Equivalents
- State Taxation of Municipal Bonds for Individuals
- Glossary
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- The Advantages of Tax Exemption
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The Advantages of Tax Exemption
Under present federal income tax law, the interest income you receive from investing in municipal bonds is free from federal income taxes.* In most states, interest income received from securities issued by governmental units within the state is also exempt from state and local taxes. In addition, interest income from securities issued by U.S. territories and possessions is exempt from federal, state and local income taxes in all 50 states.
One of the best ways to appreciate the tax-exempt advantage of a municipal security is to compare it to a comparable taxable investment. For example, assume you are in the 33% federal tax bracket, file a joint return and with your spouse, claim $185,000 in taxable income.
Now assume you have $30,000 to invest and you are considering two investment alternatives: a taxexempt municipal bond yielding 5.0%, and a taxable corporate bond yielding 7.0%. Which investment will prove most advantageous?
If you invested your money in the municipal bond, you’d earn $1,500 in interest (a 5.0% yield) and pay no federal income taxes. The taxable bond investment, however, would provide you only $1,407 in income after federal income taxes had been deducted (a 4.7% yield).
As you can see, the municipal bond would provide the best yield after taxes are taken into account. The taxexempt security would be an even better investment if you accounted for state and local income taxes when calculating returns on the taxable bond investment.
| EFFECT OF FEDERAL INCOME TAXES ON YIELDS OF TAX-EXEMPT AND TAXABLE INSTRUMENTS: | ||
|---|---|---|
| 5% Tax-exempt Bond | 7.0% Taxable Investment | |
| Cash investment | $ 30,000 | $ 30,000 |
| Interest | $ 1,500 | $ 2,100 |
| Federal income tax in the 33% marginal tax bracket | 0 | $ 693 |
| Net return | $ 1,500 | $ 1,407 |
| Yield on investment after taxes | 5.0% | 4.7% |
To determine the yield you would need to earn from a taxable investment to equal the yield on a tax-exempt security, refer to the Tax-Exempt/Taxable Yield Equivalents chart, or visit investinginbonds.com to use our Tax-Free vs. Taxable Yield Comparison Calculator online.
* If you are subject to the alternative minimum tax (AMT), you must include interest income from certain municipal securities in calculating the tax.
