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Maximize Tax Benefits of Municipal Bonds

By Russell Wild

Most municipal bonds are tax-free, but your personal federal tax bracket, as well as the income taxes you pay in your state or to your local government, have a great bearing on whether munis make sense for you. If you decide to invest in munis, what kind should you select: national or local?

You need to consider a great many things when choosing which munis to buy. Obviously, one is your personal tax bracket. You also need to take a close look at the yields of bonds issued in your home state as compared to those issued elsewhere. But yield and taxes should never be your only considerations. You should always keep diversification in mind.

If you’re only investing in AAA-rated bonds, you might be best off investing in all home-state bonds to take advantage of their double- or triple-tax-free status. If you are considering bonds with a higher default risk, you should spread out your risks geographically.

Consider your tax bracket when selecting munis

When looking at a national muni — a bond that is exempt from federal tax only — it isn’t very hard to determine whether your after-tax take-home will be greater with that bond or with a fully taxable bond. For illustration purposes, suppose you are comparing two bonds: a $5,000 Metropolis 20-year muni paying 5 percent, and a $5,000 taxable bond from the International Dummies Consolidated Corporation (IDCC) paying 6.5 percent.

First, determine your tax bracket. You can easily locate this information online from a site such as Laws.com. Your tax bracket shows the likely percent of tax you’ll pay on any interest from a taxable bond (unless that bond is held in a tax-advantaged account, such as an IRA).

Okay, got your tax bracket? Good. Now you can compare the take-home from the IDCC taxable bond to the federally tax-exempt Metropolis municipal 20-year bond paying 5 percent a year.

Start with 100. Subtract your tax bracket. Suppose you are in the 28 percent bracket: 100 – 28 = 72. That number — 72 — is the reciprocal of your tax bracket. When you have the reciprocal, divide the municipal yield by the reciprocal and it tells you, just like magic, what you would have to earn on the taxable bond to equal the amount you would get on the tax-exempt muni.

So, in this particular case, Metropolis muni is paying 5 percent. Divide 5 by 72 (the reciprocal of your tax bracket), and you get 6.94 percent.

That number, 6.94, represents your tax-equivalent yield, or your break-even between taxable and tax-exempt bond investing. If you can get 5 percent on a muni versus 6.94 percent on a taxable bond, go flip a coin. It won’t matter which you choose, as far as take-home pay. (Of course, other factors may matter, such as the quality or the maturity of the bond.)

If the taxable bond is paying more than 6.94 percent, the taxable bond is likely your better bet. If the taxable bond is paying less than 6.94 percent, you’re better off with the muni. If the IDCC taxable bond is paying only 6.5 percent, you are better off, most likely, with the Metropolis tax-free bond paying 5 percent.

So far, so good?

Consider your home state when selecting munis

Life in these United States is rarely simple. Chances are that you live in a state with income tax. Most people do.

In that case, figuring out your tax-equivalent yield is no longer a simple matter. State taxes, you see, are deductible from your federal taxes. So to figure out your tax-equivalent yield requires more math than any normal person with an Internet connection should ever have to suffer.

Log onto one of the tax-equivalent yield calculators. A good one is the Dinkytown.net Financial Calculators website. Click Investments in the column on the left side of your screen. Then click on Municipal Bond Tax Equivalent Yield. Plug in your state income tax, and the calculator shows you the tax-equivalent yields, in colorful chart form, for federally exempt munis as well as munis exempt from state and local taxes.

Don’t know your state tax? You can look that up online also; Bankrate.com offers a handy tool on their State tax rates page that can help.

Match munis to the appropriate accounts

Municipal bonds, like any tax-free investment, make most sense in a taxable account. In fact, putting a tax-free muni into any kind of tax-advantaged account, such as an IRA or Roth IRA, makes about as much sense as putting a kidney pie on a vegetarian buffet.

If you’re looking to fill your IRA with fixed-income investments (which may or may not make sense), don’t be looking at munis that are tax-exempt. Taxable bonds generally provide greater return, and if the taxes can be postponed (as in an IRA) or avoided (as in a Roth IRA), then taxable bonds are almost always the way to go.