Assessing the Suitability of Tax-Free Munis for Your Portfolio A great way for investors to contribute to the infrastructure of the communities in which they live is by investing in tax-free municipal bonds. This stream of passive income comes from the interest coupon. It won't just be tax-free income that will help you. You'll also make a difference by contributing to the cost of building hospitals, bridges, sewers, schools, and other services. If you're a citizen of the United States with a sizable net worth, municipal bonds will most likely be included in your portfolio at some point. It's best to become acquainted with them as soon as possible so that you'll be more at ease with their benefits and drawbacks when you start writing checks to purchase them.
Relevant Lessons
- States and local governments can raise funds for their budget needs by selling municipal bonds.
- Municipal bonds, which bear interest when redeemed, are, in essence, loans to local governments.
- On any interest you receive, there is no federal income tax due. At the state level, some bonds are also exempt from taxation.
- Interest is frequently lower than what you would get from a corporate bond. However, after taxes, you might be better off.
Tax-Free Municipal Bonds: What Are They?
Debt securities include municipal bonds, also referred to as munis. Cities, counties, and states issue them to help pay for routine operations and unique projects, like a new school or road. You are making a loan to the government when you buy a bond. It guarantees to pay back both your principal and interest. Frequently, interest is paid every two years. Federal income tax is not applicable to these bonds. If you reside in the state where they were issued, they might also be exempt from state or local taxes.Municipal Bond Types
Municipal bonds come in two varieties: revenue bonds and general obligation bonds, or GOs for short. The "full faith and credit" of the issuing government is pledged as security for general obligation bonds. This means that the local governments that issued them have the authority to levy taxes to cover your debt plus interest. Projects like sewer systems and schools are funded with the help of these bonds. The taxing authority of a government does not support revenue munis. There is a chance that with these munis, investors won't have many options if the revenue stream stops.Municipal Bonds' Tax Benefits
Municipal bonds are appealing due to the tax treatment that rewards you for making a social investment. These securities are not subject to federal taxes, according to the government. If you reside in the state where the municipal bond was issued, you will also not be required to pay state taxes.Who Should Purchase Municipal Tax-Free Bonds?
For the right investor, such as high earners in states like California, where tax rates on those with high incomes are the highest in the country, tax-free municipal bonds can be very nice holdings. Even though they appear to yield much less than corporate bonds, tax-free municipal bonds can actually yield higher on an after-tax basis. To ascertain whether this is the case, calculate the taxable equivalent yield.Knowledge of Taxable Equivalent Yield
When choosing between municipal and corporate bonds, you'll need to figure out a way to compare the two yields on an equal footing. Using taxable equivalent yield, you can accomplish this. The calculation of taxable equivalent yield for municipal bonds is straightforward: Yield That Isn't Taxed ÷ (1 - highest tax rate applied to investor earnings) Let's say you make a low seven-figure income and reside in California. On your highest income, you pay 13.3 percent in state taxes and 37% at the federal level. However, since federal taxes can be subtracted from state tax calculations, you would actually only be required to pay the 13.3 percent state tax on 63 percent of your pre-tax earnings, adding an additional 4.92 percent tax to the 37 percent you already pay to the IRS. In order to calculate the taxable equivalent yield, you would therefore use the variable at 41.93 percent.Example of After-Tax Bond Income Calculation
Imagine you are looking at a Riverside, California, tax-free municipal bond. Standard & Poor (S&P) has rated it AA, and Moody's has given it an Aa2 rating. It has a maturity date of Aug. 1, 2032, but because it can be called, the yield to maturity is higher than the yield to worst, which is 2.688 percent. Assume that the worst-case scenario actually occurs. Pick the rate of 2.688 percent. How much of a yield on a corporate bond would be required to give you the same after-tax income? Put the following information into the taxable equivalent yield formula: Step 1: 2.688 ÷ (1 - 0.4193) (1 - 0.4193) Step 2: 2.688 ÷ 0.5807 Solution: 4.63 percent To end up with the same amount of after-tax income as the tax-free municipal bond you're considering, you'd need corporate bonds of comparable quality maturing in August 2032 to pay you 4.63 percent to break even. The only comparable bonds are General Electric Capital's Dec. 15, 2032, AA+ by S&P, and A1 by Moody's rated bonds with a yield to maturity of 3.432 percent. Since they cannot be called, there is no yield to worst. That rate is insufficient. Under these circumstances, you wouldn't want to purchase taxable corporate bonds. They are too unattractive due to your opportunity cost.How to Benefit from Asset Placement
You can arbitrage the tax code by employing a tactic known as asset placement. This entails placing the appropriate asset in the appropriate vehicle to maximize benefits and reduce your tax liability. Municipal bonds are already tax-protected, so you wouldn't decide to own them inside a tax haven like a Roth IRA. The more lucrative corporate bonds would be better for your IRA, so you should purchase them. As long as the boundaries of that particular account protect them, those bonds are exempt from federal and state taxes. Tip: Tax-free municipal bonds are frequently not used by non-profit organizations, charitable institutions, or certain pools of capital, such as endowment funds for higher education. They'll be able to locate a better offer elsewhere almost always. Your taxable brokerage account is the best place to hold tax-free municipal bonds to benefit from the tax exemptions.How to Pick the Right Bonds to Buy
Information on municipal bond issues can be difficult to find. To evaluate the quality of a specific bond, you would need to put in a lot of time and effort. In an effort to draw in investors, many municipalities will pay bond rating agencies to assign ratings to their tax-free municipal bonds. This may only seem reasonable if you're investing hundreds of thousands of dollars. Tip: As more investors show interest, more people will place bids on the bonds. By reducing the interest rate and yield, helps the municipality save money. The bond rating agency's analysts take their time determining the value and security of a municipal bond issue. They consider factors like the interest coverage ratio to decide whether a bond should be considered an investment grade. Non-rated municipal bonds exist in some cases. If you don't want to support this particular bond issue at all, you might consider passing entirely. If you do, however, you might be more exacting in your search for a margin of safety.How Safe Are Your Tax-Free Bonds?
In his book "Security Analysis," the father of value investing, Benjamin Graham, offers some advice for determining the security of your tax-free municipal bonds. To support the cash flows, you almost always need to have the minimum population requirements, a track record of on-time bond payments, and a diverse underlying economy. The person in charge of servicing the interest payments is the one you should find out about first. The bond's future principal maturity is the responsibility of whom? What are the issuer's economic fundamentals in terms of both its capacity and its willingness to fulfill its commitments?The Bottom Line
Considerations for other categories of fixed-income securities must also be taken into account. If you're considering the timing of your cash flow or planning a long-term investment, you'll be able to lower your risk. Establishing a municipal bond ladder will increase your effective yield. Inflation risk is something else you should consider. Watch the issuer of the bonds and their financial situation as well. Take a look at the evolution of Detroit's fortunes. Check to see if you won't need to sell a bond before issues are too severe to be fixed and your principal is at risk.