What is a Municipal Bond?
We built this city; we built this city on rock' n' roll, built this city on rock' n' roll." You undoubtedly have heard this song by Jefferson Starship, and now you are singing it out loud and can't get it out of your head—sorry!
However, with all due respect to Jefferson Starship, tax-free municipal bonds help fund the building of most cities. Local or state agencies issue bonds to help build roads, dams, bridges, schools, and other public works, and you probably voted on a bond referendum or two over the years.
When you vote on bond issues, you're allowing the local government to issue bonds to finance a project in your city or county. The bonds are funded by your taxes or the services you use, like a toll road.
General obligation bonds can tax you and your neighbors to pay the interest and are some of the safest tax-free bonds to own.
Revenue bonds generate income from a project, and the project's revenue will fund the bond payment. Typical revenue bond projects include airports, public works, hospitals, and toll roads, and a portion of the money collected from the projects will go to the bond debt service.
Because municipal bonds benefit the public good, the interest you receive is tax-free. The tax-free income incentivizes investors to buy bonds to help local authorities raise money for their projects—schools, roads, etc. The interest is free from local, state, and federal taxes, called triple tax-free.
Municipal bonds are an excellent choice for high-income earners, especially if you live in a state like California or New York. The higher your taxable income, the higher the after-tax return on your investment.
The taxable equivalent yield can help you find competitive rates relative to taxable bonds. For example, a San Diego general-obligation bond paying four percent tax-free interest equates to a six percent taxable bond. To find the taxable equivalent yield, multiply the coupon rate on the tax-free bond by 1.5. In this example, a four percent coupon times 1.5 equals six percent. I use 1.5 as a quick way to find the taxable equivalent rate. The actual formula is the coupon divided by one minus your tax bracket, which looks like this: coupon divided by (1 ˗ your tax bracket). If you're in the 35 percent tax bracket, the formula is four percent/ (1 ˗ 0.35) = 6.15 percent. If you find a taxable bond paying six percent or more for the same time frame, purchasing the taxable bond makes sense.
If you live in a state with an income tax, buy bonds issued by that state where you live because you'll pay an income tax if you buy one from another state. For example, if you live in California and buy a Florida bond, your income is taxable at the state level. If you live in a state with no state income tax, like Texas, you can buy bonds issued by any state.
Tax-free municipal bonds may increase your after-tax income, especially compared to CDs, corporate bonds, and US Treasuries.
The hardest thing in the world to understand is the income tax. ~ Albert Einstein
March 3, 2023
Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM's custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on your asset level.
Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren't suitable for every investor. Prices and yields are for today only and are subject to change without notice.