Municipal Bonds: When "Tax-Free" Isn’t So Free

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Municipal Bonds: When "Tax-Free" Isn’t So Free
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
January 11, 2006

For important prospectus offering and research disclosures, please see the bottom of this article.

Reprinted from the November 2005 issue of Schwab Investing Insights™, a bimonthly publication for clients of Schwab Advised Investing Signature™ and Schwab Private Client™.

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.

Muni tax appeal
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. 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

*Average 20-year yield for AA rated municipal and corporate bonds as of Nov. 11, 2005.
Source: ValuBond.

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.

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, 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.

Perilous pitfalls
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.

Bottom line
Remember, it's not what you make but what you keep that counts. Talk to your Schwab Investment Consultant for more information about fine-tuning your bond portfolio for maximum tax efficiency.

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 877-5-SCHWAB. Please read the prospectus carefully before investing.

Bond values will decline as interest rates rise.

When a bond is purchased or sold, Schwab charges a commission, markup, or markdown. Individual bonds are subject to the credit risk of the issuer. Changes in interest rates can affect a bond’s market value prior to call or maturity. Bonds are subject to credit, interest rate, and inflation risks. In addition, bonds incur ongoing fees and expenses. A bond fund’s Net Asset Value will fluctuate with the price of the underlying bonds and portfolio turnover activity. Return of principal is not guaranteed.

Income from municipal bonds may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based upon this information.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

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