Deciding to Buy Municipal Bonds
Municipal bonds may seem like a perfect investment. Income that isn't subject to taxes—what could possibly go wrong? Not much, especially if you stick to the higher-rated issues, but that doesn't make munis right for everyone.
First, a quick recap: Municipal bonds are issued by cities, counties states, and other municipal authorities as a way of raising revenue for earmarked public projects. The interest rate paid by munis tends to be lower than that of corporate bonds. However, because the ventures they're financing are considered to serve the greater good, the interest is free from federal income tax—and state and local taxes as well, if it's issued in your locality.
When an investor buys a muni, he’s expressing a willingness to forgo a higher yield on his investment dollars in exchange for not having to pay taxes on the gain. That’s a pretty good move for high-income individuals, but buying a taxable bond that pays a higher interest rate usually makes more sense for the rest of the world. So where do you and your net worth stand on the should-I-or-shouldn’t-I muni scale? Answering a few key questions should help you figure that out, and ultimately decide if these instruments make sense for you.
What’s Your Federal Tax Bracket?
If you don’t know the answer, call your accountant. If you don’t have an accountant, get one. If you’re one of those do-it-yourself types who won’t get an accountant, take the time to research your tax bracket. You can't assume that it stays the same from year to year if your income fluctuates.
What’s Your Reciprocal Bracket?
Subtract your tax bracket from 100 to get your reciprocal bracket. For example, if you've determined that you're in the 32 percent bracket, then 100 less 32 is 68. So your reciprocal bracket is 68 percent.
What’s the Interest Rate on the Muni?
The top-rated 10-year tax-exempt bonds yield anywhere from 2.6 to 3.05 percent as of December 2018, but it can depend on the year or even on the week or the month. We'll use the upper figure in this scenario.
What’s Your Tax-Equivalent Yield?
Here’s where you decide if a particular muni is for you. Divide its yield—let's say, 3.05 percent—by your reciprocal rate of 68 percent and you’ll get 4.48 percent. That’s your tax-equivalent yield—your muni tipping point, so to speak. It means that, with everything else such as maturity and rating being equal, a taxable bond has to yield more than 4.48 percent to make more sense than the 3.05 percent tax-exempt bond for someone in your tax bracket.
Where Do You Live?
Earnings on all muni bonds are exempt from federal income taxes, but you’ll pay local taxes on muni earnings from bonds outside your state. If you buy one in the state in which you live, though, there's a good chance that the interest from it won't be subject to state and local taxes, either (these are known, respectively, as "double-exempt" and "triple-exempt" bonds). So if you reside in a high-tax state like California or New York, buying a local muni bond will add to your tax break. Calculate your state and local tax rate and your reciprocal rate, then duplicate the process that's explained above.
You can also use a web-based calculator to run these numbers. After you've done so for a few candidates, you should eventually be able to tell at a glance whether a particular muni bond makes sense for you and your portfolio.