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Is Your Tax Bracket High Enough to Justify Tax Exempt Bonds?
Interest received on most municipal bonds is not subject to federal income tax. That sounds attractive, but the real question is whether the after-tax return is more attractive than the return on a similar taxable bond or CD.
Comparing Taxable and Tax Exempt Bond Yields
The Internal Revenue Code allows individuals to treat interest income from most municipal obligations as tax exempt. This beneficial tax provision enables municipal entities to raise capital more cheaply to fund their development and operations.
For individuals, the benefit of tax exempt interest income can be attractive if they are in a high income tax bracket. To determine if the tax exempt route is right for you, it is necessary for you to compare the after tax yield of a taxable bond to the yield of a tax exempt bond. It’s important to compare bonds of similar maturity dates and similar quality.
To calculate the after tax yield of a taxable bond you can use the following formula:
AFTER TAX YIELD = YIELD – (YIELD times MARGINAL TAX RATE)
For example, here is the equation to calculate the after tax yield of a taxable bond with a yield of 6% for someone in the 35% marginal tax bracket.
AFTER TAX YIELD = 6% – (6% X .35)
= 6% – (2.1%)
Or you can use the following table:
|Tax free yield||Equivalent taxable yield in these tax brackets|
The tax brackets are those in effect in 2018.
According to the chart, a tax-exempt bond yielding 4.0% has an equivalent after-tax yield of 6.0% for someone in the 33% tax bracket. For that person, a taxable bond yielding more than 6.0% will produce a better after tax return.
Remember, to get a true comparison, it is critical that the taxable and tax exempt bonds have similar maturity dates and similar quality ratings.
* Non-Deposit investment products (NDIP) are not insured Adams Community Bank deposits and are not FDIC insured. These products are not endorsed, recommended, or guaranteed by Adams Community Bank or any government agency. The value of investments may fluctuate, the return on investments is not guaranteed, and loss of principal is possible.