At first glance, "munis" may not seem so attractive. Interest rates are low on taxable investments. In fact, you can get the same rate of return from short-term investments that you can get on a tax-free bond, and money markets don't make you tie up your money. So what's the fascination with municipal bonds?
First and definitely foremost, that "low interest rate" you may have seen advertised can be deceptive. Interest from municipal bonds is generally free from state and federal taxes, provided you buy bonds issued by your state of residence. Exceptions include Illinois, Iowa and Kansas, where state taxes are charged on interest, and Florida, Nevada and Texas, which levy no state or local income taxes. While interest is tax-free, capital gains on the sale of the bonds are subject to tax. Income for some investors may also be subject to the federal Alternative Minimum Tax, so consult your tax and financial advisors before you invest.
Many investors are turned off by municipal bonds because of their paltry yields. After all, why invest in a AAA-rated 30-year municipal bond paying only 5.25 percent when you can purchase a Treasury bond of the same maturity yielding 6.13 percent? You don't have to be a rocket scientist to figure that one out . . . or do you? Financial advisors are fond of saying it's not what you make on an investment, it's what you keep. Let's compare the two aforementioned investments after federal taxes, considering a 30-year AAA-rated insured municipal bond yielding 5.25 percent vs. a 30-year Treasury bond yielding 6.13 percent.
Taxable equivalent yields:
- An investor in the 39.6 percent federal tax bracket: 8.69 percent
- The 36 percent tax bracket: 8.2 percent
- The 31 percent tax bracket: 7.61 percent
- The 28 percent tax bracket: 7.29 percent
The winner and heavyweight champion? You guessed it: For high-income investors, municipal bonds generally provide better after-tax returns. The secret is to look beyond the initial coupon at the after-tax yield before you shy away from municipal bonds.