Municipal bonds, which are issued by cities, states and other local government entities, are free from federal taxes. And if the bond is issued in the state in which you live, they're also free of state and local taxes.
But despite those advantages, munis aren’t for everyone.
When an investor buys a muni, he’s expressing a willingness to forgo a higher yield on his investments in exchange for not having to pay taxes. That’s a pretty good move for high-income individuals.
But for the rest of the world, buying a taxable bond that pays a higher interest rate usually makes more sense.
So where do you (and your net worth) stand on the should-I-or-shouldn’t-I muni scale?
You'll need to ask yourself a few questions before deciding if you should buy municipal bonds:
- What’s my 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, then take the time to find out your tax bracket.
- What’s my reciprocal bracket?
Subtract your tax bracket from 100 to get your reciprocal bracket. For example, if you calculated that you were in the 33 percent bracket, then 100 minus 33 is 66. Your reciprocal bracket is 66.
- What’s the rate on the muni I’m considering?
Top-rated 10-year tax-exempt bonds are yielding 3.84 percent, according to Municipal Market Advisors. Let’s use that figure for this example.
- What’s my muni tipping point?
Here’s where you decide if a particular muni is for you. Divide that yield (3.84 percent) by your reciprocal rate (66 percent) and you’ll get 5.81 percent. That’s your tax-equivalent yield. In other words, for someone in your tax bracket, with everything else being equal (maturity, rating, etc.) a taxable bond that yields more than 5.81 percent makes more sense than the 3.84 percent tax-exempt bond. You can also use a Web-based calculator to run the numbers.
- Where do I live?
All 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 reciprocal rate, then duplicate the process above.
Once you’ve run those numbers a few times, you’ll be able to tell at a glance whether a particular muni bond makes sense for your portfolio.