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Municipal bonds, or “munis,” carry an important tax feature: the
interest paid on these bonds are exempt from federal income tax, as
well as state and local income tax in the state in which they are
issued. This could mean significant savings in taxes that could otherwise
be flowing to the government. Munis are especially attractive to
investors whose tax brackets are quite high, therefore garnering them
a greater after-tax return from tax-free interest than they would realize
from taxable interest.
Let’s consider a hypothetical example of the Smiths. Currently,
they are in the 35-percent tax bracket. They are considering investing
$100,000, but are unsure of whether they would benefit from municipal
bonds. The bonds they are thinking about pay an interest rate of
6 percent. They are also looking at a bank CD for this money, which
pays 8.2 percent. Which investment could earn them a higher aftertax
return? The Smiths would earn 6 percent after tax from their
muni bond, but they would only earn 5.33 percent after tax from the
bank CD. Therefore, the muni bond would earn a greater after tax
return for the Smiths. (See Tables 7.2 and 7.3 for comparisons with
the updated tax brackets.)
(1 – tax bracket) - taxable yield = tax-free yield
(1 – .35) - 8.2% = 5.33%
When considering the tax implications of purchasing municipal
bonds versus other fixed-income investments, also determine
whether you will be paying state and local taxes on the interest and
capital gains. Usually, the muni bonds will be exempt from state and
local taxation. These are sometimes referred to as “triple-tax-free
municipal bonds” because of the income tax exemptions on the interest
and sometimes on the capital gains.
For example, the Smiths have a state income tax rate of 4.4 percent,
no local income tax rate, and they itemize their deductions.
Their effective state rate is 4.4 x (1 - .35) = 2.86 percent. Their total
tax rate is 37.86 percent. In this case, the municipal bond they are
considering would be free from state income tax, as well as federal
income tax.
However, the bank CD yield of 8.2 percent isn’t exempt from any
taxes. Therefore, their after-tax rate on the muni bond remains 6 percent,
whereas the after-tax rate of the bank CD is 5.095 percent.
(1 – .3786) - 8.2% = 5.095%
Amounts are hypothetical.
However, if the Smiths don’t itemize, or if the deductions are
mostly phased out on their federal income tax return, and the state
income tax they pay isn’t deductible or mostly deductible, their combined
effective income tax rate is 39.4 percent. Then the after-tax
yield on the bank CD would be 4.97 percent. It’s important to
remember that this analysis doesn’t apply to U.S. Treasury securities
or other direct government obligations because they are already
exempt from state and local income taxes.
(1 – .394) - 8.2% = 4.97%
Amounts are hypothetical.
There are many kinds of municipal bonds, in terms of how the
bonds are backed financially. They include general-obligation bonds,
special tax bonds, revenue bonds, insured municipal bonds and
more.
GENERAL-OBLIGATION BONDS. Municipal bonds are usually not
secured by physical property; instead, they are debts payable from
the state or local governments’ general tax revenues. G-O bonds are
normally considered to be high-quality and highly secure investments,
in line with the creditworthiness of the issuer.
HOUSING AUTHORITY BONDS. Housing authority bonds are issued
to pay for low-rent housing projects and are backed by the promise of
unconditional, annual contributions by the Housing Assistance
Administration, a government agency. These bonds are considered
among the highest in quality.
INDUSTRIAL DEVELOPMENT BONDS. These bonds are issued either
by a municipality or a municipal authority to finance and promote
areas like industrial parks. They are backed by the lease payments
made by the industrial companies that use or fill the facilities that are
paid for by the bond issue.
Municipal bonds are also rated, just like corporate bonds are. The
quality ratings for munis are second only to U.S. government and
government agency securities. Moody’s and Standard & Poor’s,
again, are the companies that rate these bonds.
INSURED MUNICIPAL BONDS. Although state and local municipalities
who issue bonds are generally thought to have good credit, and
thus, have highly rated bond issues, many muni bonds carry insurance
to protect the investors from the default risk. Any insurance carried on
the bonds strengthens their credit rating, usually up to the highest level.
REVENUE BONDS. The principal and interest on revenue bonds is
paid from the income received from specific projects or entities.
Examples of revenue bonds are water, sewer, gas, and electrical facilities;
bridges, turnpikes, tunnels and highways; and hospitals and
power plants.
SPECIAL TAX BONDS. These bonds are usually backed and payable
through a single tax, or series of special taxes. They may also be
payable through another specific income source.
Municipal bonds can be prerefunded, and are also subject to high
credit ratings. Prerefunding a bond issue means that the issuing
municipality has purchased U.S. government securities that have the
same maturity term as the municipal bond. These securities are then
held in a special account, where they are the collateral for the muni
bond, therefore reducing the risk of default.
Similar to corporate bonds, muni bonds also have an interest rate
risk and call provisions. However, you must determine whether the
tax-free interest outweighs the possibilities of having your bond
redeemed prior to maturity or having the interest rate increase. Usually,
though, investors in higher tax brackets enjoy having some
municipal bonds in their portfolios to help increase their overall,
after-tax return on their investments. | 
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