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MBA Series; BOND INVESTING – TAX FREE OR TAXABLE, WHICH TO CHOOSE?

By in Advanced Investing, Bond, Taxes | 8 comments

Tax Free or Taxable Bonds? Use a Simple Formula to Choose

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I started investing in my 20’s when I came into a small inheritance from a great aunt. My fear of the stock market and recollection of stories of the great stock market crash of 1929 led me to invest in bonds as a safer way to grow my money.

Flash forward several decades, as I prepare the lectures for my university Investments class, I am struck by how easy it is to decide whether to invest in taxable or tax free (tax-exempt) bonds.

Learn this quick and easy formula and you will never wonder again whether it is better to snatch up those state or city municipal bonds that are offered by your locale or stick with corporate bonds paying a higher yield.

tax free muni bond

What is a Bond?

First, a quick tutorial for those just getting started. A bond is a loan to a company, city, state, or federal government. In exchange for the loan, the borrower pays the lender a coupon or interest payment. When you purchase a corporate bond, you loan money to a company and pay tax on the interest income received. Corporate bond  taxable.

What are Tax Free Bonds?

A bond in which the income produced is free from federal, state and local taxes. Most tax-exempt securities come in the form of municipal bonds, which represent obligations of a state, territory or municipality. Investopedia

Purchase a bond issued by your state to improve the roads and the interest you receive is exempt from federal and state taxes. Sounds like a great deal doesn’t it? Since the bonds are tax- exempt, they usually sport lower coupon (interest) payments.

So how do you determine whether you are better off buying a 5 year municipal bond issued by your state and paying 2.5% or buying a 5 year corporate bond paying 3.5%?

Tax-free or Taxable Bonds?

There is an easy way to determine which bond offers a higher after tax return. Calculate the Tax Equivalent Yield of the tax exempt bond and compare it with the yield of the taxable bond. Then choose the one that offers the greatest after tax return.

Try it out

Let’s assume that your state and federal combined tax rate = 30%

You can purchase a 5 year taxable corporate bond with a yield = 3.5%

Or, you can purchase a 5 year tax-exempt municipal bond from your own state with a yield of 2.5%

Which is the better deal?

This simple formula will tell you in under a minute.

Tax Equivalent Yield

Compare which is higher:  municipal bond return/(1-combined tax bracket) = taxable return (or tax equivalent yield) 

Taxable return = 2.5%/(1-30%)=tax equivalent yield of 3.57%

A taxable bond must pay at least 3.57% in order to beat the 2.5% tax exempt return on the municipal bond.

Since the best return on a comparable taxable bond is 3.5%, the investor in the 30% tax bracket is better off purchasing a tax free bond paying 2.5% interest, as this yield is equivalent to a taxable yield of 3.57%.

Don’t let taxes eat up your bond returns if you’re in a high tax bracket. Figure out if tax free bonds are for you.

Can’t Get Enough Tax Free Bond Info?

What are Muni Bonds and Should I Own Any? @ Oblivious Investor

7 Pillars of Investing in Tax-Free Bonds @ Kiplingers

Put on for my City; Tax-Free Bonds @ Young Adult Finances

Investing in Municipal Bonds @ About.com

Bond Investing-What are Tax Free Bonds? @YouTube-eHow Finance

Have you considered investing in tax free bonds? 

a version of this article was previously published with comments left intact

    8 Comments

  1. Decide on your investment goals and be sure that tax-free mutual funds are the best way to meet those goals. Tax-free mutual funds help you avoid paying taxes on your principal’s interest; however, there are often early withdrawal penalties that can hit you hard. Tax-free mutual funds work best if you have a sum of money you are sure you will not need access to for some time.

    cmichaelsny

    May 8, 2012

  2. Tax-free mutual funds help you avoid paying taxes on your principal’s interest; however, there are often early withdrawal penalties that can hit you hard.

    Pershy

    May 8, 2012

  3. Hi C-Actually, I prefer individual bonds because bond mutual funds will decline in principal value with an increase in interest rates. And with today’s low rates, it’s only a matter of time before rates trend upward. If you buy individual bonds and hold them until maturity, you are certain to get the principal face value returned to you.

    Barb

    May 8, 2012

  4. I love municipal bonds for all the reasons you described – all the good it can do for a community. I think you have to be careful trying to mitigate tax situations because sometimes an AMT situation might actually do more harm than good in maximizing return.

    Nunzio Bruno

    May 8, 2012

  5. Hi Nunzio, Oh, that pesky AMT. Isn’t it about time they index it? More and more middle class people are getting caught up in the AMT. Thanks for mentioning that point.

    Barb

    May 8, 2012

  6. If a person buys bond funds, rather than individual bonds, there are additional annual fees. These are given in the expense ratio (ER). Comparing a few bond index funds show that there are differences in the ER between brokerages, as well as between types of funds (taxable versus tax free). These funds all have an average bond duration of approximately 5 years.

    Expense Ratio for some select bond funds:
    Fidelity Calif muni bond fund, 0.46%
    Vanguard Calif muni bond etf, 0.2%
    Vanguard total bond etf, 0.1%

    Bryce @ Save and Conquer

    April 1, 2014

  7. Bryce, Thanks for pointing out the variability in expense ratios. Those expenses can detract from your returns over time. Although I have accounts at Fidelity and Vanguard, Vanguard does have a reputation for rock bottom fees.

    Barbara Friedberg

    April 1, 2014

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