by Maria Crawford Scott
With yields on the safest fixed-income investments still very low, one way to boost your bottom line is to shield that income from further erosion.
Interest income that is sheltered from federal taxation—and possibly state and local taxes as well—has always been the main attraction of municipal bonds.
However, tax-advantaged bonds generally offer a lower coupon rate than taxable bonds of similar maturity, such as government bonds.
How do you compare the yields of bonds that receive different tax treatments?
A relatively simple formula can help you put the yields on an equal footing.
Your Marginal Tax Rate
The first factor in the equation is your marginal tax rate.
Your marginal tax rate is the percentage tax rate that you pay on your last dollar of taxable income; it is typically higher than or equal to your average tax rate. If you are in the higher tax brackets and subject to phaseout rules that reduce itemized deductions and personal exemptions, your real marginal rate may be a percentage or two higher than the stated percentage bracket.
While interest earned on municipal bonds is generally exempt from federal income tax, exemption of the interest from state income taxes is not uniform. You need to become familiar with the tax-exemption rules of your own state, particularly the tax-exempt status of others states’ bonds, if you want to take state and local taxes into consideration.
Keep in mind that, although interest income may be exempt from federal, state, and/or local taxes, capital gains and losses are generally taxable
at all levels.
Taxable Equivalent Yields
Assuming that the tax-exempt and fully taxable investment alternatives have similar maturities, then a simple calculation tells you the taxable equivalent yield of the tax-exempt bond:
When using this formula to obtain the taxable-equivalent yield, you should convert percentages to decimals—for example, if you are in the 35% marginal federal tax bracket (0.35 in decimal form) and you are considering the purchase of a municipal bond with a 3.33% (0.033 in decimal form) yield that is exempt from federal taxes, your calculation looks like this:
This tells you that in your tax bracket (35%), a municipal bond yield of 3.33% is equivalent to a taxable bond that has a yield of 5.08%.
If you were in the 15% tax bracket, on the other hand, the same formula would result in a tax-equivalent yield of 3.88%. This changes the picture considerably.
You can use the same formula to determine whether an in-state bond, on which you pay no state tax, would net you more than an out-of-state bond on which you would have to pay state taxes. For example, if your state tax is 5%, add that amount to your federal tax (35% in the preceding example) and substitute the resulting number (40%) in the above formula. And you can use it to compare yields on municipal bond mutual funds and exchange-traded funds with similar maturity taxable funds.
Table 1 provides the taxable equivalent yields of tax-exempt yields ranging from 1% to 6% for the current federal income tax brackets.