Municipal bonds and the tax exemption

In short

You have probably heard someone mention municipal bonds and figured they were meant for bankers. I felt that way about most money tools for years. A city or county borrows from people like you. It pays you interest along the way and hands your original money back at the end. The interest is often free from federal income tax, and sometimes from state tax too. That fact can change the math. Run the numbers for your own bracket before you decide anything.

The whole of it

What it is

A friend of mine once called a bond a plain IOU, and that is about right. A municipal bond, often called a muni, is a loan you make to a state, city, county, or other local government body. They spend the money on roads, schools, hospitals, and water systems. In return they promise a set rate of interest, called a coupon, at regular times. At the end of a fixed period, called the maturity date, they return your original loan, called the principal. Simple enough.

If you are wondering what makes munis special, it is the tax rule. Congress decided long ago that helping local governments borrow cheaply was worth some lost tax revenue. So the interest on most munis is not counted as taxable income on your federal return. That is the core of it.

How it works

You have probably noticed that two people with the same paycheck can end up with different amounts after taxes. Munis work on that same logic. Because their interest skips federal tax, you keep more of each dollar of interest you earn. A taxable bond may show a higher rate. But after federal tax takes its bite, you could keep less than a lower rate muni would pay you.

People compare the two with the tax equivalent yield. That phrase means the taxable rate you would need to earn to match what the muni pays, once taxes are counted. The formula has three steps. Take the muni's interest rate. Subtract your federal tax rate, written as a decimal, from the number 1. Divide the muni rate by that result. The answer is the rate a taxable bond must offer to leave you with the same take home interest. The worked example below shows it with real figures.

State and local tax works a little differently. A friend of mine in Illinois once told me her state bond interest never touched her state return. Many states do exempt interest on bonds issued inside that state, so an Illinois resident who buys an Illinois muni may owe no Illinois tax on it. A bond from another state may be taxed by your home state. It depends on where you live. The IRS explains the federal side on its page about tax exempt interest. Your state revenue department can answer the state side.

Not every muni is tax exempt. If you are looking at private activity bonds, which fund projects with private users, know that their interest may count toward the alternative minimum tax, or AMT, for some taxpayers. The AMT is a second tax calculation that can raise your bill. The IRS page on the AMT is worth a read if that might be you. Some munis issued for private purposes are taxable from the start. The bond's official statement, its main disclosure document, says whether the interest is exempt.

The numbers, and where to find yours

I want to be straight with you. Bond rates move every day. They depend on the borrower's credit quality, the length of the bond, and the mood of the whole market. So I will not hand you a rate and call it current. The Municipal Securities Rulemaking Board runs a free public database called EMMA, short for Electronic Municipal Market Access. It sits at emma.msrb.org. It shows official statements, trade prices, and ongoing disclosures for bonds already issued.

If you are holding your last tax return, your federal bracket is on it. The IRS publishes the bracket thresholds each year at irs.gov, and they are set by law and adjusted yearly. The current thresholds are the current figure, which the official source publishes each year. Your bracket is the percent you pay on your last dollar of income. That is the number you use in the formula. The higher your bracket, the more the exemption is worth to you.

A worked example

Meet Clara. She is a nurse in a mid size city, and she earns $95,000 a year. She files as a single person. She checked the bracket thresholds on irs.gov and found she sits in the 22 percent bracket. She has some savings she wants to put in bonds, and she is weighing two choices. One is a taxable corporate bond paying 5 percent. The other is a muni paying 3.8 percent, with federally tax exempt interest.

Clara writes the formula down. She turns 3.8 percent into the decimal 0.038. She turns 22 percent into 0.22. Then she subtracts: 1 minus 0.22 equals 0.78. She divides: 0.038 divided by 0.78 equals about 0.0487. That is roughly 4.87 percent, her tax equivalent yield.

So the muni at 3.8 percent matches a taxable bond paying about 4.87 percent. The corporate bond offers 5 percent. That is a bit higher. On the federal math alone, the corporate bond comes out a hair ahead. But Clara also lives in a state that exempts in state muni interest. Suppose her state tax rate is 4 percent and the muni is from her own state. Then she adds that saving in. Her combined rate is 22 percent plus 4 percent, which is 26 percent, or 0.26. She subtracts: 1 minus 0.26 equals 0.74. She divides: 0.038 divided by 0.74 equals about 0.0514. That is roughly 5.14 percent. Now the muni edges past the 5 percent corporate bond. The 4 percent state rate is Clara's own made up figure for this story. Your state rate may differ, so look it up. (Adding the two rates is a simple shortcut. Your own return may treat state tax differently.)

Clara does not stop there. She opens the official statement on EMMA to read the credit rating and the risks the issuer lists. That is the right instinct.

Where it goes wrong

I have watched smart people assume that tax free always means better. It does not. If you sit in a low bracket, the tax saving shrinks. A taxable bond with a higher rate might beat the muni even after tax. The math is the honest referee here. Let it speak.

Credit risk is the next trap. Local governments can run into money trouble, and some have. A bond from a stressed city carries more risk than one from a steady state. Rating firms like Moody's and S&P assign ratings to munis. The official statement on EMMA describes the issuer's finances. Read it. Do not skip it.

If you are weighing a fund over single bonds, know the trade. A fund spreads your money across many bonds. That helps with spreading risk. But a fund charges a yearly fee called the expense ratio, and that fee cuts your return. Check the expense ratio before you call a fund a clean swap.

Then there is the AMT. If it applies to you, some muni interest gets added back into your taxable income. The IRS page on the alternative minimum tax shows who it affects. It can catch people off guard.

Questions to answer before you leave this page

Before you move on, I would ask a few honest questions of myself, and I ask them of you the same way: do you know your federal tax bracket well enough to run the tax equivalent yield formula yourself, and if not, have you looked up the current brackets for your filing status on irs.gov; have you checked whether your state exempts only in state muni interest or out of state interest too, since that answer could shift your math; have you read the official statement on EMMA for any bond you are weighing, including the credit and risk sections; if you are thinking about a fund instead of single bonds, have you found its expense ratio and counted it in; and do you have a tax professional you trust who can tell you whether the AMT applies to you, since that detail is too personal for any guide to settle?