Weighing the Choice between Taxable and Tax-Free Bonds

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TAX BRACKET

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15% 25% 28% 33% 35%

Taxable Yield (%) Equivalent Tax-Free Yield (%) =

2 1.70 1.50 1.44 1.34 1.30

2.5 2.13 1.88 1.80 1.68 1.63

3 2.55 2.25 2.16 2.01 1.95

3.5 2.98 2.63 2.52 2.35 2.28

4 3.40 3.00 2.88 2.68 2.60

4.5 3.83 3.38 3.24 3.02 2.93

5 4.25 3.75 3.60 3.35 3.25

5.5 4.68 4.13 3.96 3.69 3.58

6 5.10 4.50 4.32 4.02 3.90

6.5 5.53 4.88 4.68 4.36 4.23

7 5.95 5.25 5.04 4.69 4.55

7.5 6.38 5.63 5.40 5.03 4.88 = If you're considering the purchase of an individual = bond or=20 even a bond mutual fund, one of your first concerns = will be=20 its yield. However, when comparing various yields, you = need to=20 make sure you're not comparing apples to oranges. The = yield on=20 a tax-free bond may be lower than that paid by a = taxable bond,=20 but you'll need to look at its tax-equivalent yield to = compare=20 them accurately. What's taxable? What's not? The interest on corporate bonds is taxable by = local, state,=20 and federal governments. However, interest on bonds = issued by=20 state and local governments--generically called = municipal=20 bonds, or munis--generally is exempt from federal = income tax.=20 If you live in the state in which a specific muni is = issued,=20 it may be tax free at the state or local level as = well. Unlike munis, the income from Treasury securities, = which=20 are issued by the U.S. government, is exempt from = state and=20 local taxes but not from federal taxes. The general = principle=20 is that federal and state/local governments can impose = taxes=20 on their own level, but not at the other level; for = example,=20 states can tax securities of other states but not = those of the=20 federal government, and vice versa. The impact of freedom from = taxes In order to attract investors, taxable bonds = typically pay=20 a higher interest rate than tax-exempt bonds. Why? = Because of=20 governmental bodies' taxing authority, investors often = consider munis safer than corporate bonds and are more = likely=20 to accept a lower yield. Even more important is the = associated=20 tax exemption, which can account for a difference of = several=20 percentage points between a corporate bond's coupon = rate--the=20 annual percentage rate it pays bondholders--and that = of a muni=20 with an identical maturity period. Still, depending on your tax bracket, a tax-free = bond could=20 actually provide a better net after-tax return. = Generally, the=20 higher your tax bracket, the higher the tax-equivalent = yield=20 of a muni bond will be. It's not what you get, it's what = you keep To accurately evaluate how a tax-free bond compares = to a=20 taxable bond, you'll need to look at its = tax-equivalent yield.=20 To do that, you apply a simple formula that involves = your=20 federal marginal tax rate--the income tax rate you pay = on the=20 last dollar of your yearly income. The formula depends = on=20 whether you want to know the taxable equivalent of a = tax-free=20 bond, or the tax-free equivalent of a taxable bond. = The table=20 on this page shows the tax-free equivalents of various = taxable=20 yields; the figures are determined by subtracting your = marginal tax rate from 1, then multiplying the taxable = bond's=20 yield by the result. (To see how to calculate the = taxable=20 equivalent of a tax-free bond, see box titled "When = Less Is=20 More.") If a taxable bond = also is subject=20 to state and local taxes and the tax-exempt one isn't, = the=20 tax-exempt bond's coupon rate could be even lower and = still=20 provide a higher tax-equivalent yield. Munis are tax free, except when = they're=20 not As is true of almost anything that's related to = taxes,=20 munis can get complicated. A bond's tax-exempt status = applies=20 only to the interest paid on the bond; capital gains = realized=20 from any increases in the bond's value are taxable if = and when=20 the bond is sold. Capital gains taxes also apply when = you sell=20 shares of a muni bond mutual fund. Also, specific muni issues may be subject to = federal income=20 tax, depending on how the bond issuer will use the = proceeds.=20 If a bond finances a project that offers a substantial = benefit=20 to private interests, it is taxable at the federal = level=20 unless specifically exempted. For example, even though = a new=20 football stadium may serve a public purpose locally, = it will=20 provide little benefit to federal taxpayers. As a = result, a=20 muni bond that finances it is considered a so-called=20 private-purpose bond. Other publicly financed projects = whose=20 bonds may be federally taxable include housing, = student loans,=20 industrial development, and airports. Even though such bonds are subject to federal tax, = they=20 still can have some advantages. For example, they may = be=20 exempt from state or local taxes. And you may find = that yields=20 on such taxable municipal bonds are closer to those of = corporate bonds than they are to tax-free bonds. Agencies and GSEs (government-sponsored = enterprises) vary=20 in their tax status. Interest paid by Ginnie Mae, = Fannie Mae,=20 and Freddie Mac bonds is fully taxable at federal, = state, and=20 local levels. The bonds of other GSEs, such as the = Federal=20 Farm Credit Banks, Federal Home Loan Banks, and the = Resolution=20 Funding Corp. (REFCO), are subject to federal tax but = exempt=20 from state and local taxes. Before buying an agency = bond,=20 verify the issuer's tax status. Don't forget the AMT To even further = complicate=20 matters, the interest from private-purpose bonds may = be=20 specifically exempted from regular federal income tax, = but=20 still may be considered when calculating whether the=20 alternative minimum tax (AMT) applies to you. Even if = you are=20 not subject to the AMT when you purchase a bond, more = people=20 are feeling its impact each year, and the interest = from a=20 private-purpose bond could change your AMT status. A = financial=20 professional can determine the likelihood that a bond = will=20 affect your AMT liability. Pay attention to muni bond = funds Just because you've invested in a municipal bond = fund=20 doesn't mean the income you receive is automatically = tax free.=20 Some muni funds invest in both public-purpose and=20 private-purpose munis. Those that do must disclose on = their=20 yearly 1099 forms how much of the tax-free interest = they pay=20 is subject to AMT. Use your tax advantage where it = counts Be careful not to make a mistake that is common = among=20 people who invest through a tax-deferred account, such = as an=20 IRA. Because those accounts automatically provide a = tax=20 advantage, you receive no additional benefit by = investing in=20 tax-free bonds within them. By doing so, you may be = needlessly=20 forgoing a higher yield from a taxable bond. Tax-free = munis=20 are best held in taxable accounts. A financial professional can help you compare = taxable and=20 tax-free bonds, and determine how to maximize the = benefits of=20 both.