In Addition To The Risks What Other Factors Should You Consider When Investing In Municipal Bonds
Tax implications. Consider consulting a tax professional to discuss the bond’s tax implications, including the possibility that your bond may be subject to the federal alternative minimum tax or eligible for state income tax benefits.
Broker compensation. Most brokers are compensated through a markup over the cost of the bond to the firm. This markup might be disclosed on your confirmation statement. If a commission is charged, it will be reported on your confirmation statement. You should ask your broker about markups and commissions.
The background of the broker or adviser selling the bond. A securities salesperson must be properly licensed, and, depending on the type of business the firm conducts, his or her firm must be registered with the MSRB and with FINRA, the SEC or a state securities regulator. You can check out an investment adviser on the SEC’s Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov and a broker on FINRAs BrokerCheck website at www.finra.org/brokercheck. To confirm MSRB registration, you can review the MSRBs registered dealers list at .
A Framework For Evaluating The Tax Exemption Of Municipal Bond Interest
The debate over the tax exemption of municipal bond interest is sometimes dominated by anecdotes and narrow arguments. Opponents of the exclusion tend to draw attention to the most prominent abuses of the current system, such as the use of tax-exempt municipal bonds to fund local stadiums and arenas. Meanwhile, proponents of the exclusion often highlight particularly attractive state and local infrastructure projects that are subsidized by tax-exempt bonds, without considering larger policy questions.
It would be more productive for the policy community to consider large structural questions about the exclusion of municipal bond interest than to dwell on the specific merits of the thousands of state and local projects funded by the provision. As a starting point for this discussion, the following framework may be useful for evaluating the exclusion of municipal bond interest:
The next three sections of this paper will address these questions.
Tax Advantages Of Munis
Most municipal bonds have an advantage that sets them apart from other debt instruments: Their interest payments are tax free at the federal level. Theyre often tax-free at the state level, too, if you live in the state where they were issued.
Because they arent paying a portion of their interest income to the government, investors are willing to accept lower interest payments on tax-free munis. Those in higher tax brackets tend to win out by purchasing such bonds, because their tax-equivalent yieldwhich takes into account the tax bite from other fully taxable bondsis still relatively high. The higher the , the more attractive these bonds become.
You can calculate the tax-equivalent yield for a muni by using the following formula:
Municipal bond yield ÷ = tax-equivalent yield
For example, take an investor in the 35% federal tax bracket. This individual would have to pay a 35% tax on interest income from most bonds. However, with a tax-free muni, a 5% yield would have a tax-equivalent yield of 7.7%.
5.0% ÷ = 7.7%
Assuming a similar level of risk, a tax-free muni with a nominal yield of 5% would be more favorable to this investor than taxable bonds with a 6% or even a 7% yield.
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Taxation Of Federal Government Bonds
Income from bonds issued by the federal government and its agencies, including Treasury securities, is generally exempt from state and local taxes.
If you own a bondmutual fund or ETF , you’ll need to calculate the amount of income you earned from the fund’s government bond holdings in order to take advantage of this exemption when you file your taxesit won’t be reflected on the tax forms issued by your investment company.
Q: I Need To Buy Some New Bond Investments Im Torn Between Longer
If you are investing in an IRA or other tax-advantaged account like a 401, it never makes sense to buy tax-free bonds. Money withdrawn from tax-deferred retirement accounts is taxable as ordinary income, no matter how it was invested within the account.
Assuming that youre investing in a taxable brokerage account, the answer is a little more complicated. Generally speaking, tax-free municipal bonds pay lower interest rates than taxable bonds of the same maturity length and credit quality. What you need to determine is whether the tax advantages make up for the lower rate.
Heres a simplified example. Lets say that AAA-rated tax-free bonds with 30-year maturities yield 2.5%, while a 30-year Treasury bond yields 3%. If youre in the 12% federal tax bracket, this brings your effective yield from the Treasury bond down to 2.64%, so it would still be the better option. On the other hand, if youre in the 22% federal tax bracket, it makes your effective Treasury yield just 2.34%, so the tax-free bond would be the better choice.
State taxes could make the benefit even better.
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Are Municipal Bonds Always Tax
Municipal bonds can be an attractive investment if youre looking for bonds that generate consistent income with low credit risk. Tax-free municipal bonds may be even better since theyre tax-exempt in nature. But theres one thing to know about investing in muni bonds: tax-exempt status is not always guaranteed. There are certain scenarios in which you may still have to pay taxes on income from municipal bonds. If you hold these bonds in your portfolio or are thinking of investing in them, its important to understand what that could mean from a tax perspective.
A financial advisor can help you sort out your retirement accounts and create a plan for retirement. Find a financial advisor today.
Are Municipal Bonds A Good Investment In 2021
On the plus side, highly-rated municipal bonds are generally very safe investments compared to almost any other investment. The default rate is tiny. As with any bond, there is interest rate risk. If your money is tied up for 10 or 20 years and interest rates rise, youll be stuck with a poor performer.
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How Does The De Minimis Tax Rule Work
Using the de minimis tax rule:
1. Multiply the face value by 0.25 percent.
2. Multiply the result by the number of complete years between the discounted bond’s purchase date and maturity date to determine whether a municipal bond is liable to capital gains tax or ordinary income tax.
3. Subtract the bond’s par value from the computed de minimis sum, which leads us to the minimis threshold.
The acquired bond is liable to ordinary income tax if this sum is greater than the discount bond’s purchase price. In addition, capital gains tax is imposed if the acquisition price exceeds the de minimis limit.
Suppose the market discount is smaller than the de minimis amount. In that case, the discount on the bond is frequently recorded as a capital gain instead of ordinary income upon sale or redemption.
A fundamental rule of bond pricing is that bond prices decline as interest rates rise and vice versa. The de minimis tax rule often applies when interest rates are increasing. As a result, bonds cost less during these times and are offered at discounts or significant discounts to par.
For example, assume a company has issued a bond for 13 years and has a face value of $4,675. The bond matures in 8 years.
Following the steps above, the de minimis threshold becomes:
The bond may only be acquired for this amount for the IRS to record the discount as a capital gain.
How Much Do Municipal Bonds Earn
Muni bonds often have lower yields than corporate bonds and other taxable bonds. Municipal bond rates are lower because they are considered relatively safe as compared to other assets. However, its important to note that the tax efficiency of municipal bonds also plays a role in their desirability.
For example, lets say youre in the 24% federal income tax bracket. You find a municipal bond with a tax-exempt yield of 5%. To get the same after-tax income benefit from a taxable bond, youd need a yield of 6.6%. The difference is even more pronounced at a higher tax bracket. In the 35% tax bracket, youd need a yield of 7.7% to see the same benefit in a taxable bond.
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Example Of Calculating After
Say you are looking at a tax-free municipal bond for Riverside California rated AA by Standard & Poor and Aa2 by Moodys. It matures on Aug. 1, 2032, but it is , so the yield to maturity of 2.986% is higher than the yield to worst, which is 2.688%. In this case, for the sake of conservatism, well assume the yield to worst actually comes to fruition and go with the 2.688% rate. How much would a corporate bond need to yield to provide you that same after-tax income? Wed take the taxable equivalent yield formula and plug in what we know:
- Step 1: 2.688 ÷
- Step 2: 2.688 ÷ 0.5807
- Answer: 4.63%
That is, to end up with the exact same amount of after-tax income, youd need corporate bonds of comparable quality maturing in August of 2032 to pay you 4.63% just to break even with the tax-free municipal bond youre considering.
Now consider that the only comparable bonds are rated AA+ by S& P and A1 by Moodys for General Electric Capital maturing on Dec. 15, 2032, with a yield to maturity of 3.432%. They are non-callable so there is no yield to worse.
That rate isnt good enough. You wouldnt want to buy taxable corporate bonds under these conditions your opportunity cost makes them too unappealing.
What Are Some Of The Risks Of Investing In Municipal Bonds
As with any investment, investing in municipal bonds entails risk. Investors in municipal bonds face a number of risks, specifically including:
Call risk refers to the potential for an issuer to repay a bond before its maturity date, something that an issuer may do if interest rates decline — much as a homeowner might refinance a mortgage loan to benefit from lower interest rates. Bond calls are less likely when interest rates are stable or moving higher. Many municipal bonds are callable, so investors who want to hold a municipal bond to maturity should research the bonds call provisions before making a purchase.
This is the risk that the bond issuer may experience financial problems that make it difficult or impossible to pay interest and principal in full . Credit ratings are available for many bonds. Credit ratings seek to estimate the relative credit risk of a bond as compared with other bonds, although a high rating does not reflect a prediction that the bond has no chance of defaulting.
Inflation risk. Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest. It also can lead to higher interest rates and, in turn, lower market value for existing bonds.
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What Are Municipal Bonds And How Do They Work
Municipal bonds are issued by state and local governments to raise money for public projects such as schools and roads. General obligation bonds are used for projects that arent likely to generate revenue, while revenue bonds are paid back with revenue from specific projects, such as a toll road or an entertainment center.
While municipal bonds may not sound like the most exciting investment, they typically come with the benefit of no federal taxes. Plus, in many cases you may not owe state or local taxes either. Because of this tax advantage, a lower yield on a municipal bond may actually be more attractive than a higher-yielding taxable bond once you adjust for the tax savings.
Heres how it works: Imagine youre a high earner with a federal income tax rate of 37 percent and a state tax rate of 7 percent. Youre considering a municipal bond with a yield of 3 percent and a taxable bond with a yield of 4 percent.
Tax-equivalent yield = Interest rate /
Youll see that the municipal bond has a tax-equivalent yield of almost 4.8 percent based on just the federal tax savings, and the tax-equivalent yield rises to 5.4 percent when you account for the additional state tax savings, both of which outpace the 4 percent yield on the taxable bond.
Higher Premiums And Taxes
Although tax-exempt muni bond interest may be appealing, those earnings may increase Social Security taxes and Medicare premiums, said Tracy Sherwood, a Williamsville, New York-based CFP at Sherwood Financial Management.
That’s because the formulas for Social Security taxes and Medicare Part B and Medicare Part D use so-called modified adjusted gross income, or MAGI, which includes tax-exempt muni bond interest.
If half of Social Security payments plus MAGI is more than $44,000 for a joint tax return , up to 85% of Social Security benefits may be taxable.But with relatively low thresholds, it’s difficult for some higher-income retirees to avoid paying tax on 85% of Social Security payments, Sherwood said.
The bigger issue is that retirees with income above certain thresholds may owe a surcharge for Medicare Part B and Part D known as the Income Related Monthly Adjustment Amount.
The base amount for Medicare Part B premiums in 2022 is $170.10 per month, a 14.5% jump from 2021. However, the payments start to increase for joint filers with MAGI over $182,000 .
“That’s where you’re looking at premiums going up by about $70 or more per month,” said Sherwood. “That’s pretty significant.”
The top Medicare Part B surcharge is $578.30 for couples filing together with MAGI at $750,000 or above.
Retirees may also see premium increases for Medicare Part D, which typically covers prescription drugs, with the top surcharge at $77.90 for the highest earners in 2022.
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Reason #2 To Like Munis: Be Greedy When Others Are Fearful
So far 2022 has not been kind to municipal bonds. As of April 12, 2022, the S& P Municipal Bond Index is down 6.78% for the year. Investors may have been spooked by events in Ukraine, inflation and the prospect for higher interest rates.
This is reason No. 2 why I like muni bonds. Research from investment firm Lord Abbett looking back over the past 12 years has shown there have been six distinct outflow cycles for muni bonds, and in the subsequent 12-month period the performance was overwhelmingly positive. Past performance is no guarantee of future results, but strong performance has typically followed large outflows in municipal bond funds.
How Are Municipal Bonds Taxed
A bond is a debt security issued by a company or government to raise money and cover spending needs. A municipal bond, also known as a muni, is debt security used to fund capital expenditures for a county, municipality, or state. Municipal bonds are commonly tax-free at the federal level but can be taxable at state or local income tax levels or under certain circumstances.
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Why The Surge Now
One big reason is a provision of the 2017 Tax Cuts and Jobs Act, which prohibited the use of tax-exempt bonds for advanced refunding transactions, a refinancing maneuver we describe below. Previously, when interest rates declined, issuers of tax-exempt municipal bonds could issue a second tax-exempt bond to refinance their debt. Now, entities that want to use advanced refunding must issue taxable bonds.
Heres how it works: Say a city issues a tax-exempt bond at a 4% interest rate. A few years later, interest rates drop, and now investors will accept 1.5% on a tax-exempt bond. Before 2017, the city would have issued a second tax-exempt bond, and essentially redeemed the outstanding portion of the initial bond, similar to a homeowner refinancing a mortgage. In practice, the city takes the proceeds from the second bond, and invests the funds in an escrow account. The interest earned on those funds pays the debt service on the first bond issued, and the citys total borrowing costs fall.
With the 2017 Tax Cuts and Jobs Act, the city can only issue these refinancing bonds if they are taxable. However, current interest rates on taxable muni bonds are so low that the advanced funding maneuver is still attractive. In the second half of 2019, nearly 80% of taxable bonds were used at least partly for this type of refinancing.
Types Of Municipal Bonds
Municipal bonds come in the following two varieties:
- general obligation bonds
- revenue bonds
General obligation bonds, issued to raise immediate capital to cover expenses, are supported by the taxing power of the issuer. Revenue bonds, which are issued to fund infrastructure projects, are supported by the income generated by those projects. Both types of bonds are tax-exempt and particularly attractive to risk-averse investors due to the high likelihood that the issuers will repay their debts.
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Why Investors Buy Bonds
Investors buy bonds in order to create a reliable stream of income while preserving their capital
Many investors devote a portion of their overall holdings to bonds in order to offset the greater risks inherent in almost any other type of investment, notably stocks. That is the purpose of diversification: Low-risk investments cushion potential losses from higher-risk investments. Even bonds are not risk-free. The risk is that the issuer will default on its debts.
Investors can judge the risk level of a bond they are considering by checking the bond’s rating. All bonds sold in the U.S. are rated by one of three bond-rating agencies: Moody’s Investors Service, S& P Global, or Fitch Ratings. Bond ratings are based on an analysis of the creditworthiness of their issuers.