Municipal Bonds: When 'Tax-Free' Isn't So Free

Municipal bonds have long been an attractive investment option for tax-sensitive investors, because muni bonds are free of federal income tax--and often state tax as well. Add in the fact that munis generally have relatively higher credit quality and lower price volatility than comparable taxable bonds, and municipal bonds could trump corporate bonds even if you're not in the top tax bracket.

But there are at least two instances when you need to look beyond your marginal tax bracket to see if muni bonds 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 discuss how to determine if municipal bonds really make sense from a tax perspective.

Muni tax appeal

Depending on your marginal income tax bracket, muni bonds can be attractive if you live in a high-tax state like California or New York, since you can potentially avoid both federal and state income taxes with bonds issued by your state of residence. Even without the double advantage of in-state bonds, simply avoiding federal income tax on municipal interest income can be significant, as the following table shows:

It's what you keep that counts 

 

 

Federal Marginal Income Tax Rate

 

Yield*

15%

25%

28%

33%

35%

39.6%

Municipal bond

3.64%

3.64%

3.64%

3.64%

3.64%

3.64%

3.64%

Corporate bond

3.99%

3.39%

2.99%

2.87%

2.67%

2.59%

2.41%

*Average 20-year yield for AAA-rated municipal and corporate bonds as of July 31, 2013. Source: ValuBond.

Based on the rates above, munis could make sense for taxpayers in all tax brackets. 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 possible that taxpayers in brackets above the 15% federal bracket could benefit from holding in-state municipal bonds in their taxable accounts.

Devil in the details

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, comparable munis 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.

Perilous pitfalls

The first pitfall involves the taxation of Social Security income. Although municipal 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 municipal bonds of comparable maturity and quality, it's generally not nearly enough to overcome the AMT hit.

Fortunately, you can avoid individual private activity bonds. And if you’re considering a muni-bond mutual fund, you can check the prospectus to see if the fund avoids private activity bonds by prospectus mandate or, at least, by management choice.

Bottom line

Remember, it's not what you make but what you keep that counts. Talk to a Schwab Fixed Income Specialist at 877-563-7818 for more information about fine-tuning your bond portfolio for maximum tax efficiency.

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