Deciding To Buy Municipal Bonds

expressway funded with municipal bonds
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Municipal bonds may seem like a perfect investment. They yield 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.

Learn how to choose municipal bonds that fit your budget and needs.

Key Takeaways

  • Municipal bonds are issued by cities, counties, states, and other municipal authorities as a way of raising revenue for earmarked public projects.
  • When an investor buys a ​municipal bond, they're willing to forgo a higher yield on their investment dollars in exchange for not having to pay taxes on the gain.
  • Top-rated 10-year tax-exempt bonds yield anywhere from 2.90% to 3.40%, but it can depend on the year, week, or month.

What Are Municipal Bonds?

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, they're expressing a willingness to forgo a higher yield on their 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" municipal bonds scale?

You can use the Electronic Municipal Market Access (EMMA) provided by the Municipal Securities Rulemaking Board (MSRB) to find information on specific bonds.

How to Decide on Municipal Bonds

Answering a few key questions should help you decide whether 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% bracket, then 100 minus 32 is 68. So your reciprocal bracket is 68%.

What’s the Interest Rate on Municipal Bonds?

The top-rated 10-year tax-exempt bonds yield anywhere from 2.90% to 3.40%, but it can depend on the year, week, or month.

What’s Your Tax-Equivalent Yield?

Here’s where you decide whether a particular muni is for you. Divide its yield—let's say, 1.20%—by your reciprocal rate of 68% and you’ll get 1.76%. 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 1.76% to make more sense than the 1.20% tax-exempt bond for someone in your tax bracket.

Alternatively, you can divide the bond's yield by one minus your federal tax bracket to get a bond's tax equivalent yield, or By÷(1 - Ftb). So if you're looking at a bond with a yield of 3.5% and you're in the 32% federal tax bracket, you'd calculate .035 ÷ ( 1-.32 ) = 0.0515, or 5.15%.

Where Do You Live?

Earnings on all muni bonds are exempt from federal income taxes, but you’ll pay local taxes on municipal bond 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 such as California or New York, buying a local muni bond will add to your tax break. Calculate your state and local tax rates and your reciprocal rate, then duplicate the process that's explained above.

What It Means for Investors

Determining the best municipal bond is overly complicated, but it's a necessary step when you're trying to find one that meets your goals, investing strategy, and financial circustances. Muni investing also doesn't need to be about only the best return, it gives you chance to help your community fund the projects you think deserve to funded.

If you don't want to run the numbers manually, you can always find a web-based calculator to run these numbers. A quick search for a "Tax Equivalent Yield Calculator" will turn up several results.

After you've compared 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.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal

Article Sources

  1. Municipal Securities Rulemaking Board. "EMMA."

  2. FMSbonds. "Municipal Market Yields."

  3. U.S. Securities and Exchange Commission. "Investor Bulletin. Municipal Bonds: Understanding Credit Risk," Page 1.