How to Tell If Munis Are Right for You
Some investors will receive higher after-tax yields from tax-exempt municipal (muni) bonds than from taxable bonds. To find out what’s best for you, you must crunch some numbers.
Try an online calculator
One option is to use one of several online calculators to help you determine your personalized tax-exempt yield.
Example 1: Ashley Burns enters her federal tax rate of 33% into an online calculator. She also enters her North Carolina state tax rate of 7.75%. Ashley enters 4% as the current tax-exempt yield from a muni bond fund. The calculator shows her “tax-equivalent” yield to be 6.49%. That is, if Ashley earns 6.49% on a taxable bond and pays federal as well as state income tax on her interest income, she’ll net the same 4% interest she can get from the muni bond fund she is considering.
Real world math
A second option is to compare the after-tax yield you’d receive on a taxable bond with the yield of a tax-exempt bond using real world numbers.
Example 2: Suppose Ashley can earn 5% interest from a hypothetical mutual fund that invests in Treasury bonds or 4% interest from a hypothetical fund that invests in high quality tax-exempt muni bonds. Because both funds hold intermediate term bonds, their exposure to interest rate risk is similar.
If Ashley receives 5% interest from this Treasury bond fund and pays 33% of it to the IRS, she will net 3.35%. She will owe no tax to North Carolina because Treasury bond interest is exempt from state and local income tax. Thus, Ashley will earn more, after tax, from this muni bond fund than from this Treasury bond fund.
Example 3: Ashley’s son Eric is in a 15% federal tax bracket. If Eric invests in the Treasury bond fund yielding 5% and pays 15% to the IRS, he will net 4.25% after tax. Therefore, Eric will earn more after tax from the Treasury bond fund than from the muni bond fund.
Example 4: Ashley also is considering a bond fund that holds high quality intermediate term corporate bonds. It yields 6%. However, Ashley would owe income tax to North Carolina as well as to the IRS on that 6% interest. She can deduct the tax she’ll pay to North Carolina on her federal tax return, which will reduce the effective federal tax she’ll pay. Ultimately, Ashley will owe about 38% in tax on that 6% yield, so she’ll net about 3.7% after tax. Her after-tax yield would be lower than the muni fund’s 4%. (The math would be different if Ashley were subject to the alternative minimum tax and, consequently, could not deduct state tax payments on her federal tax return.)
Typically, the higher your tax bracket, the greater the advantage of muni bonds and muni funds. Many observers expect tax rates to increase in the next few years, especially for high-bracket taxpayers. Our office can help you determine whether you will earn higher yields, after tax, from taxable or tax-exempt investments.
2009 Tax Brackets
| Tax rate | Single filers
taxable income |
Married filing jointly
taxable income |
| 10% | Not over $8,350 | Not over $16,700 |
| 15% | $8,351–$33,950 | $16,701–$67,900 |
| 25% | $33,951–$82,250 | $67,901–$137,050 |
| 28% | $82,251–$171,550 | $137,051–$208,850 |
| 33% | $171,551–$372,950 | $208,851–$372,950 |
| 35% | $372,951 or more | $372,951 or more |
Copyright © 2009 by the American Institute of Certified Public Accountants, Inc., New York, NY 10036-8775.