When it comes to bond yields, sometimes less is more. While municipal bonds, or “munis,” usually have a stated yield several percentage points below those on comparable corporate or government bonds, the interest paid on municipal issues is generally exempt from federal and, in some cases, state and local taxes. For that reason, a muni may actually provide a similar or higher yield than those other options after taxes are taken into account.
Are Munis Right for You?
You can easily compare the yield on a muni with a taxable investment to help determine whether tax-exempt investing might benefit you. For example, if your income tax rate is 25%, a $1,000 municipal bond yielding 6% may actually be a better investment than a taxable bond yielding 7.9%. Why? While the taxable bond will provide $79 in interest per year, federal taxes will leave you with $59.25. The muni, on the other hand, may pay $60 a year free of taxes.
To determine whether you might come out ahead with a muni, use this formula to calculate its taxable-equivalent yield:
Municipal bond fund yield / (1 – your marginal tax rate) = taxable-equivalent yield
For example: 6.0% / (1 -.25) = 8.0%. In this instance, if you are in the 25% federal tax bracket, a taxable investment needs to yield 8.0% to equal the lower, but tax-exempt, return offered by a municipal bond that currently yields 6%.
How Should You Invest in Munis?
In addition to the thousands of municipal bond issues that are outstanding at any one time, professionally managed funds offer you additional alternatives for investing in munis. Municipal bond funds generally invest in a diversified mix of high-quality bonds whose interest income may be exempt from federal and state taxes. In addition, with initial investment requirements that are generally lower that those for individual municipal bonds, funds that invest in them may make it easier for more investors to participate in the muni market.
Note that investments in Municipal bonds are subject availability and change in price. Market and interest rate risks exist if sold prior to maturity. Bond values will decline as interest rate rise.
If you’d like help determining whether you might benefit from an investment in a municipal bond or bond fund, be sure to consult a qualified financial professional.
Investors should consider the investment objectives, risks, charges and expenses of the investment company carefully before investing. The prospectus contains this and other information about the investment company. You can obtain a prospectus from your financial representative. Read carefully before investing.
Income from some municipal bonds may be taxable under alternative minimum tax rules. Capital gains are taxable.
Lower maximum tax rates on capital gains, dividends and other income would make the return of the taxable investment more favorable, thereby reducing the difference in performance between the accounts shown. Also, changes in lax rates and tax treatment of investment earrings may impact the comparative results and investors should consider their personal investment horizon and income lax bracket, both current and anticipated before making an investment decision.