When evaluating tax-free municipal bond investments you must first determine the “equivalent taxable yield” of the bond. This is done by subtracting your effective tax rate from 100% and dividing the tax-free yield by the result.
Let us say you are a NJ resident in the 25% federal and the 5.525% state tax brackets. You will be able to itemize, so you save 25% of the 5.525% state tax. Your effective tax rate is 29.144% (5.525% x 75% = 4.144% + 25%). 100% - 29.144% = 70.856%.
A 3% yield on a NJ municipal bond is equal to earning 4.23% on a taxable investment (3% divided by 70.856% = 4.23%). A NJ muni paying 3.5% will pay the same as a taxable bond or CD paying 4.94% (3.5% divided by 70.856% = 4.94%).
If you are looking at a bond from another state (you live in New Jersey but the bond is issued by a Florida municipality) you would only factor in your federal tax bracket. If that is 25% you would divide the muni yield by 75% to determine the equivalent taxable yield.
Not a math wizard. For a helpful “Tax-Free Vs Taxable Yield Calculator” you can go to www.investinginbonds.com and click on “Calculators”.
While it is true that interest on the obligations of a state or local government is exempt from federal income taxes under IRC Section 103(a), tax-free bond income is not always tax free. You should take the following facts into consideration before you decide to invest in a tax-free municipal bond or bond fund.
* Tax-free income from state and local municipal bonds and municipal bond funds is included in the calculation of the taxable portion of Social Security and Railroad Retirement benefits. In certain situations, each $1.00 in tax-free bond interest can result in an additional 85 cents of taxable income!
* Tax-free income from “private activity bonds” is considered a “tax-preference” for purposes of calculating the dreaded Alternative Minimum Tax (AMT). If you are a victim of the AMT the interest from these bonds is taxed at a rate of 26% or 28%.
* The interest on state or local bonds or bond funds, while exempt from federal taxation, may be taxed on your resident or non-resident state tax returns. For example, interest from a NJ bond is exempt on the NJ resident and non-resident returns, but income from a Massachusetts municipal bond is not. Similarly, a NJ resident with income from a multi-state municipal bond fund must pay NJ state tax on that portion of the income that is attributable to the fund’s investments in non-NJ bonds.
* If you sell a tax-free bond, or shares in a tax-free bond fund, for more than your cost, you must pay federal income tax on the capital gain. If you buy a bond for $10,000 and sell if for $10,500 the $500 gain is taxable. However, if, instead, you sell the bond for $9,500 you have a deductible $500 capital loss. Any “accrued interest” that is part of the purchase or sale price of the bond is not included in determining the gain or loss when the bond is sold.
* If you borrow money to buy shares in a tax-free bond fund on “margin”, the interest charges are not deductible as investment interest on Schedule A.
As with any investment, changes in interest rates could affect the value of a municipal bond or shares in a muni bond fund. If you believe that interest rates will rise in the near future it would be wise to limit your consideration to short-term and intermediate-term bonds.
PS - Tax-exempt interest from municipal bonds and municipal bond funds are included in the calculation of income for determining if you must pay a higher Medicare Part B premium.