Muni tax appeal
Devil in the details
Perilous pitfalls
Municipal bonds have long been an attractive investment option for tax-sensitive investors, because munis are free of federal income tax and often state tax too. Add in the fact that munis generally have relatively higher credit quality and lower price volatility than comparable taxable bonds, and munis could trump corporate bonds even if you're not in the top tax bracket.
But there are at least two instances where you need to look beyond your marginal tax bracket to see if munis are right for you. If you receive Social Security benefits or are subject to the Alternative Minimum Tax (AMT), your tax-free muni income may not be so free after all. We'll show you how to determine if munis, for all their current allure, are really right for you.
Depending on your marginal income tax bracket, munis can be especially attractive if you live in a high-tax state like California or New York, since you can avoid both federal and state income taxes with bonds issued by your state of residence.
Based on the rates above, munis would make sense for anyone in tax brackets of 28% or higher. In fact, a taxpayer in the 35% bracket would need a taxable bond yield of 6.15% just to break even with a 4% muni yield on an after-tax basis [.04 ÷ (1–.35) = .06154]. Throw in state taxes, and it's likely that just about anyone above the 15% federal bracket could benefit from holding in-state muni bonds in their taxable accounts.
Calculating the tax-equivalent yield is an important step in deciding whether taxable or muni bonds make sense for you. But the analysis shouldn't stop there. Actually, municipal bonds would look even better in cases where the alternative taxable interest income makes you ineligible for certain tax breaks based on a higher adjusted gross income (e.g., retirement or education tax breaks), or if taxable interest income caused you to lose some of your itemized deductions or personal exemptions, as is the case when higher taxable income causes a phase-out of these benefits.
The first pitfall involves the taxation of Social Security income. Although muni bond interest income is generally free from federal income tax, the IRS considers that interest part of your "modified adjusted gross income" for determining how much of your Social Security benefits, if any, are taxable. Let's say you're married and filing jointly. If half of your Social Security benefits plus other income, including tax-exempt muni bond interest, is more than $32,000 ($25,000 for single filers), up to 85% of your Social Security benefits are taxable.
If you are caught by this "stealth tax," a simple tax-equivalent yield comparison between a muni and taxable bond alternative wouldn't provide a complete and accurate picture of your after-tax returns. Depending on your income, it might pay to run some "what if" analyses to see how much you're really keeping after taxes under different scenarios.
The second pitfall involves so-called private activity bonds, which are issued to fund stadiums, hospitals, housing projects and so on. While interest from these bonds is generally free of ordinary income taxes, that income is included as part of the AMT calculation. If you're subject to AMT, the interest you thought was free from income tax could end up getting taxed at a rate of 28% on the margin-which means a 4% yield shrinks to 2.88% after taxes! Although private activity bonds generally sport a slightly higher yield than regular munis of comparable maturity and quality, it's generally not nearly enough to overcome the AMT hit.
Fortunately, it's easy to avoid individual private activity bonds. And if you use muni bond mutual funds, you can simply check the prospectus to see if the fund avoids private activity bonds by prospectus mandate or, at least, by management choice. For example, the Schwab California Tax-Free YieldPlus Fund (SWYKX) is AMT-free by prospectus mandate, whereas the managers at the American Century Tax-Free Bond Fund (TWTIX) have expressed their intent to avoid private activity bonds.
