Municipal bonds at the top rate

In short

A friend of mine once showed me two statements side by side and asked why the smaller number made him happier. One bond paid 3.4 percent and was free of federal tax. The other paid 5 percent and was fully taxed. He had stopped at the bigger number, and I understood why. If you are in the top federal bracket, the right question is how much you keep, so the comparison starts after tax. A municipal bond is a loan to a state, city, or agency, and its interest is often exempt from federal income tax. At the top rate of the current figure, which the official source publishes each year, that exemption is worth the most. To compare fairly, divide the tax free yield by one minus your total tax rate. Check whether the bond is subject to the alternative minimum tax, since some are. Read the official disclosure for any bond before you rely on a tax claim about it.

The whole of it

What it is

I once sat beside a man at a county fair who had built a long career lending to his neighbors. He said the best loan he ever made was to the town that fixed the bridge everyone used. A municipal bond is that same idea at larger scale. A state, city, school district, or public agency borrows money from investors and promises to repay it with interest. The borrower is the issuer. The lender is the person who buys the bond.

The tax treatment is what sets these bonds apart. Under federal law, interest on many municipal bonds is exempt from federal income tax. The Internal Revenue Service explains this in Topic No. 403, Interest Received, and in Publication 550, Investment Income and Expenses. Many states also exempt interest on bonds issued within their own borders, though the rules differ from state to state.

Not every municipal bond gets this treatment. Some are taxable at the federal level. Some carry an alternative minimum tax, or AMT, feature, which means the interest can be pulled into a separate tax calculation. The official statement for each bond says which kind it is. Reading that document is worth the time.

How it works

You have probably noticed that a rule of thumb gets repeated a lot: tax free bonds pay less, so they only suit people in high brackets. There is real sense in that, and the arithmetic shows why.

Think of two bonds with the same safety and the same length. One is a municipal bond and one is a taxable corporate bond. The municipal bond pays less interest on its face. But the corporate bond interest gets taxed before you see it, and the municipal interest does not. The right way to compare them is the taxable equivalent yield. That is the tax free yield divided by one minus the tax rate.

Two federal taxes can apply to a top earner. One is the ordinary income tax rate. The other is the net investment income tax, which the IRS explains in the instructions for Form 8960. Interest from a municipal bond that is exempt from regular federal tax is generally not counted in net investment income. That detail matters, because it makes the exemption worth a little more than the bracket alone suggests.

Then there is the state. A resident of a state with an income tax can sometimes also avoid state tax by buying bonds from that same state. A resident of a state with no income tax gets no such extra benefit, and the comparison gets simpler.

One more thing deserves a plain word. The tax break is already priced in. Markets know about it, which is why municipal yields sit below taxable yields. The break does not make the bond cheap. It only changes who keeps what.

The numbers, and where to find yours

I once helped a neighbor look for a single figure on a tax form, and we spent an hour because neither of us knew which page to open. So here is where each number lives.

Your bracket comes from the tax rate schedules the IRS publishes each year. The top federal rate on ordinary income is the current figure, which the official source publishes each year. The income level where that rate begins is the current figure, which the official source publishes each year for married couples filing together. Both figures change with the law and with inflation adjustments, so the site fills in the current ones with their source and date.

The net investment income tax rate is the current figure, which the official source publishes each year. It applies above an income threshold that the IRS lists in the instructions for Form 8960. Your state rate comes from your state revenue department, and it is worth looking up the exact figure instead of guessing.

The yield on a specific bond is printed on the trade confirmation and in the official statement. Look for the yield to maturity, which is the return if the bond is held until it repays. The official statement also states whether the bond is tax exempt, whether it is subject to AMT, and what rating agencies have said about the issuer. Bond disclosures for most municipal issues are posted on EMMA, the Electronic Municipal Market Access website run by the Municipal Securities Rulemaking Board. It is free to search.

Last, your own tax picture matters. A top rate on paper is not always the rate you pay on the next dollar. Deductions, credits, and the AMT can all shift it. Your return and a tax professional can confirm the real figure.

A worked example

Let me tell you about a woman named Marguerite. She sold a company and now has $40,000,000 in cash to put to work. She lives in a state with no income tax, so only federal tax is in play. For the sake of the example, assume her total federal rate on interest is 40.8 percent. That is a plain figure chosen for the story, not a law or a limit.

She is weighing two bonds that are alike in safety and length. A municipal bond yields 3.4 percent and is exempt from federal income tax. A corporate bond yields 5 percent and is fully taxable.

First, the after tax result on the corporate bond. The tax takes 40.8 percent, so she keeps 59.2 percent. That is 1 minus 0.408, which is 0.592. Then 5 percent times 0.592 is 2.96 percent, which is the same as $2.96 kept on every $100 of corporate bond value.

Second, compare that to the municipal bond. It pays 3.4 percent and no federal tax is taken. So she keeps all 3.4 percent. The municipal bond wins by 0.44 percentage points, because 3.4 minus 2.96 is 0.44.

Third, find the taxable equivalent yield, which tells her what a taxable bond would have to pay to match. Divide 3.4 by 0.592. The answer is 5.74 percent. A taxable bond would have to pay 5.74 percent to leave her with the same 3.4 percent.

Now scale it. Say she puts $5,000,000 into the municipal bond. At 3.4 percent, the interest is $170,000 a year. She owes no federal tax on it. The same $5,000,000 in the corporate bond at 5 percent pays $250,000. Tax at 40.8 percent takes $102,000. She keeps $148,000. So the municipal bond leaves her $22,000 more each year, which is $170,000 minus $148,000.

Marguerite felt good about that. Then she did what careful people do and read the official statement. That brings us to the trouble spots.

Where it goes wrong

I once saw a fine plan fall apart over a single footnote. It happens more often than people admit, so here is where the footnotes hide.

The first trouble is the AMT feature. Some municipal bonds, often called private activity bonds, can have interest that counts toward the alternative minimum tax. If the buyer is hit by that tax, part of the benefit shrinks or goes away. The official statement says whether a bond carries this feature.

The second trouble is credit risk. An issuer can fall behind on payments. Safety differs a great deal from one issuer to the next, and a rating is only one opinion. The tax break does not protect the lender from a default.

The third is price risk. If market rates rise, the price of an existing bond falls. A buyer who holds to maturity gets the face amount back, but a buyer who must sell early can take a loss. A bond can also be called, which means the issuer repays it early, often when rates have dropped. Then the buyer has to reinvest at lower rates.

The fourth is concentration. At tens of millions, a single issuer or a single state can become a very large share of the pile. A problem in one place then hits hard. Spreading across issuers is a way to see the risk, though it is a question for an adviser and not a prescription here.

The fifth is the comparison itself. A taxable equivalent yield only works when the bonds are truly alike. A longer bond, a lower rated bond, or a callable bond can make the yield look better for reasons that have nothing to do with tax.

Last, the law can change. The tax rate, the exemption, and the rules around them are set by Congress and can be rewritten. A figure that is true today may not stay true.

Questions to answer before you leave this page

Do you know your actual tax rate on the next dollar of interest, including any net investment income tax and any state tax? Have you opened the official statement for the bond you are looking at and checked whether it is exempt from federal tax, and whether it carries an AMT feature? If you buy from your own state, do you know whether that state exempts the interest, and does it matter if you live in a state with no income tax? What is the yield to maturity, and what happens to that yield if the bond is called early? Are you comparing bonds of the same length and the same credit quality, or is something else hiding in the gap between the two yields? How much of your total pile would sit with one issuer, and how would you feel if that issuer ran into trouble? And have you shown the numbers to a tax professional who can see your whole return?