When seeking tax-efficient investments, many people immediately think of municipal bonds. But not all municipal bonds are tax-exempt, and those that are tax-exempt are generally more appropriate for investors in higher tax brackets.
Tax-free municipal bonds typically provide income that is exempt from federal taxes and, depending on the state where they were issued and your state of residence, they might also be exempt from state taxes as well. Because of their tax-free status, municipal bonds usually pay lower yields compared to similar-risk taxable-bonds, so investors should look at the tax-equivalent yield when comparing bonds.
To determine the tax-equivalent yield, multiply the interest rate on the taxable bond by the reciprocal of your tax bracket.
TEY = I/Yr x (1 - tax rate).
Where TEY = Tax Equivalent Yield, I/Yr = Interest rate.
For example, if a municipal bond is paying 4% and a taxable bond is paying 5%, an investor in the 15% tax-bracket would likely choose the taxable bond since his after-tax return on the taxable bond would be 4.25%, making it more attractive than the 4% tax-free bond. An investor in the 28% federal tax bracket would likely choose the lower-interest municipal bond because the after-tax yield of 4% is more attractive than the after-tax yield of the higher-interest taxable bond, which only yields an after-tax return of 3.6%.
Also, while interest income is usually tax-exempt for municipal bonds, capital gains are usually not tax-exempt. Capital gains realized from selling a bond are subject to federal and state taxes.
And remember, not all bonds are equal. Be sure to look at two critical components when evaluating any bond: Maturity date and credit quality. In general, bonds with longer maturities carry higher risk as do bonds with lower credit quality. Since risk and return are related, bonds paying higher interest generally carry more risk than bonds paying lower interest.