Tax exempt investing can save you thousands in taxes on municipal bonds with strong ratings
When is a lower return a good thing? When that lower return saves you money in taxes.
This is the case with tax-exempt investing in municipal bonds, debt issued by states and other public institutions.
Too many investors screen exclusively for return, yield in the case of bonds, and then invest at the highest listed rates. Bonds are an interesting case since credit rating agencies like Standard & Poor’s assigns all investments to a credit rating. In theory, the bonds within each rating should offer similar rates or return.
Investors simply picking bonds with the highest yields could be missing out on thousands, sharing most of their gains with Uncle Sam.
Let’s first look at municipal bonds before exploring whether tax-exempt investing is right for you and how to save thousands for your financial goals.
What are Municipal Bonds?
Bonds are loans to a company, government or public entity like the water or gas authority. Even the U.S. government borrows money and that money is raised through issuing bonds to investors. Bonds generally pay interest twice a year and then return the face value of the debt at the end of the bond’s maturity.
Municipal bonds (munis) are debt issued by local governments; states, cities, counties and public institutions like schools or utilities. The debt can be needed for a number of reasons including new construction or special projects.
Munis are usually issued as either general obligation (GO) or revenue bonds. GO muni bonds are backed by the credit of the issuer. Since the issuer, the state or local government, has the power to raise taxes to pay its debt – these bonds are usually extremely safe.
Revenue bonds are supported only by the revenue coming specifically from the project funded by the debt. Yields on these are usually higher because the risk is higher. The issuer can default on a revenue bond without being forced into bankruptcy. Still, revenue bonds are generally pretty safe as well because income from projects can be estimated from tolls or specific taxes.
As a way to make it easier for states and local governments to raise money, the interest paid on municipal bonds is exempt from federal income taxes. Some munis also provide tax-exempt income within the state where they are issued.
This tax-exempt status of municipal bonds make them extremely attractive investments, especially to investors in higher tax brackets.
How Much Do Investors Earn on Municipal Bonds?
The tax-exempt status of municipal bonds attracts a lot of investors and that means yields are pushed down. Issuers are able to offer bonds at lower rates compared to taxable bonds from corporations because they will still attract investor money.
Yields for 10-year municipal bonds are averaging 2.19% versus a yield of 2.25% for the U.S. Treasury Bond and 3.14% on bonds issued by A-rated corporations.
This difference in yields is confusing though because the after-tax return is different for municipal bonds. Since there is no income tax on these investments, the return might actually be higher than these other bonds.
The ultimate return to tax-exempt investing depends on your income tax rate. The higher your ordinary income tax rate, the higher the comparable yield will be for municipal bonds compared to taxable bonds.
This is called the tax-equivalent yield.
If I haven’t scared you off yet from all this talk about taxes and bond investing, you might just be able to save thousands at tax time.
Is Tax-Exempt Investing Right for YOU?
Determining if you’ll save money by investing in municipal bonds is a fairly easy process. You simply need to compare tax-exempt municipal bonds with taxable bonds.
To do this, you need to find the tax-equivalent yield of the muni bond. That means finding how much yield the municipal bond would have to offer if it was taxable to equal the same return as it does currently.
Tax Equivalent Yield = Municipal Bond Yield / (1 minus tax rate)
Don’t let the math scare you, it’s actually very easy. If you are in the 35% tax bracket then (1 minus tax rate) equals 0.65
Then you just take the yield offered on the municipal bond and divided it by that number.
For example, a muni bond with a yield of 3% has a tax-equivalent yield of 4.62% for someone in the 35% tax bracket (3% divided by 0.65).
Conversely, that same 3% tax-exempt bond would only have a yield of 3.53% for an investor in the 15% tax bracket (3% divided by 0.85).
Once you know a tax-exempt bond’s equivalent yield, you can compare it with any other taxable bond. If the municipal bond offers a higher rate based on your tax bracket, then you’ll save money with tax-exempt investing.
Those savings can add up big time. Consider two investors, one in the 35% income bracket and the other in the 15% bracket. The investors have a choice between a municipal bond that pays a 4% yield or a corporate bond paying a 5.5% yield. The credit ratings and maturities for the bonds are the same. Each investor is trying to decide what to do with a $100,000 investment.
The investor in the 15% tax bracket would earn $4,675 in interest after taxes each year in the corporate bond or $4,000 from the municipal bond. The choice is obvious.
The choice is also obvious for the investor in the 35% tax bracket. They would earn $3,575 in interest after taxes each year on the corporate bond or $4,000 from the municipal bond.
In fact, the corporate bond would have to offer a yield of 6.15% to draw the higher tax bracket investor away from the muni bond.
State and local taxes, and whether a municipal bond is exempt there as well, will also factor into the investment decision.
It may seem like a long way to go to pick investments but there are advantages. If you are in the higher tax brackets, there’s a good chance you can take advantage of tax-exempt investing to save money on taxes.
One last consideration is where you hold your investments. Since you don’t pay taxes on retirement accounts like Individual Retirement Accounts (IRAs), it doesn’t make sense to hold tax-exempt investments in these accounts. You are already getting a tax break so you don’t need another.
Instead, hold taxable bonds like corporates in your retirement accounts and tax-exempt bonds in regular investing accounts. This also goes for other types of investments, i.e. hold dividend-paying stocks in retirement accounts while stocks that pay no dividend and are only taxed when you sell them should be held in regular investing accounts. This 
minimizes your taxes as much as possible.
Bond investing is a critical part of your overall investment strategy, whether you benefit from tax-exempt investing or not. Bonds provide stability and consistent cash flow even when stocks are tumbling. Whether you're 25 or 55, you need some of your portfolio in bonds to avoid the roller-coaster of stocks. Check out Step-by-Step Bond Investing for a detailed guide on the different types of bonds and how to get the most from fixed-income investments.
Tax-exempt investing is too often neglected by investors because it involves one more step in the decision-making process. For investors in higher tax brackets, investments in municipal bonds might end up saving thousands of dollars versus other bonds. Make sure you understand at which point you should start investing in tax-exempt bonds.
