Deciding if You Should Buy Municipal Bonds
Municipal bonds are issued by cities, states, and other local government entities as a way of raising revenue for earmarked public projects that are considered to serve the greater good. Gains they produce are free from federal taxes, and there's a good chance that they're free of state and local taxes as well if they're issued in the state in which you live. Does this make munis a perfect investment? Maybe not.
How to Know if Munis Are Right for You
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? Ask yourself a few key questions before deciding if you should buy municipal bonds:
- 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 33 percent bracket, then 100 less 33 is 66 so your reciprocal bracket is 66 percent.
- What’s the rate on the muni you're considering? The top rated 10-year tax-exempt bonds yield anywhere from 2 to 3.35 percent as of October 2017, 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 muni tipping point? Here’s where you decide if a particular muni is for you. Divide the yield—in this case, 3.35 percent—by your reciprocal rate of 66 percent and you’ll get 5.07 percent. That’s your tax-equivalent yield. In other words, with everything else such as maturity and rating being equal, a taxable bond that yields more than 5.07 percent makes more sense than the 3.35 percent tax-exempt bond for someone in your tax bracket. You can also use a web-based calculator to run the numbers.
- 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. So if you live 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 should be able to tell at a glance whether a particular muni bond makes sense for your portfolio after you've run the numbers a few times.