Lesson 1: Suitability

Basic Arithmetic Tells You When You Belong In Municipal Bonds

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Any extra income that doesn’t add to one’s taxable income bracket increases in value by the amount of the taxes saved. Say you earn 5% taxable and file a joint return this year on $250,000 in New York City.  After the IRS, the Governor, and the Mayor take their cut, you wind up with 3%.  Not a very lordly return when the bond of any municipality in NYS paying 5% lets you keep the 5%. The demand for income that lets an investors keep 100 cents on the next dollar earned without bumping them into higher tax brackets has ramifications for municipal issuers. Our cities and towns are able to borrow for public necessities in the tax free bond market at below taxable market rates.  Although that means their munis pay less nominally than comparable taxables, upper bracket muni buyers aim to come out significantly ahead in taxes saved than in interest forgone.

BELONGING IN MUNIS

That’s where this business of belonging or not belonging in municipal bonds comes in.  Individuals in low to no tax brackets are usually better off in taxables – and paying any applicable tax.  Belonging in munis, i.e. suitability, is a function of one’s own personal income tax bracket.  Step One in deciding if municipal bonds are for you would be bringing up the Taxable Equivalent Yield Table for the state where you pay tax and running your finger across the row with your income and tax bracket and down the column with the tax-free yield under consideration. At the intersection is the interest rate the taxable investment would have to pay you before taxes to net the same take-home interest the municipal bond pays you tax-free.

Click on your state, and download the Taxable Equivalent Yield Table:

AL | AK | AZ | AR | CA | CO | CT | DE | DC | FL | GA | HI | ID | IL | IN | IA | KS | KY | LA | ME | MD | MA | MI | MN | MS | MO | MT | NE | NV | NH | NJ | NM | NY (outside NYC) | NYC | NC | ND | OH | OK | OR | PA | PR | RI | SC | SD | TN | TX | UT | VT | VA | WA | WV | WI | WY |

Below is a more conservative if less dramatic way to compare tax-free munis to taxable investments: The What's-Left-In-Your-Pocket-After-Taxes Table.

MUNIS AND INFLATION

Caveat Number One. It’s not how much you earn that counts.  It’s how much you keep – after taxes and inflation.  Munis eliminate taxation from the equation. But inflation comes right off the top, leaving you with a Real Rate of Return which is the take-home pay you pocket after inflation.

As we've said, inflation is the scourge of any fixed-income investment. Using the full height of the graph (black+shaded) to represent the Bond Buyer 20-Bond Index, an average of 20 representative long term general obligation bonds, and the Consumer Price Index (CPI) to represent inflation (black), the real rate of return after inflation (BBI-CPI = RRR) ranged from 3tablet.76 percent in 2001…to a low of 0.78 percent in 2005…to a high of 5.24 percent in 2008 when the CPI was 0.4 percent and the full yield of the muni was all yours to keep. In 2010, with the BBI-20 at 4.26 percent for the year and the CPI at 1.6 percent, the Real Rate of Return was 2.66 percent.

Caveat Number Two. In determining how much a dollar of income that’s tax free is worth in your bracket, compared to your takehome from a taxable investment, just make sure you compare apples to apples, taxable alternatives of comparable maturity and quality. It’s loading the deck in favor of the muni to get into the routine of comparing them to, say, Treasuries or bank CDs, when CDs are federally insured. And there’s a penalty but no market risk for redeeming a CD before it matures.  If you have to sell a bond prematurely, you may make money or lose money, generally depending whether interest rates are higher or lower than when you originally bought your bond.

After-Tax Yields of Alternatives To Tax-Free Municipal Bonds

Find income bracket in Column A and read across. Take a husband and wife who file a joint return in 2011 on $250,000 after deductions and adjustments. They are in a 33% federal income tax bracket (Column B). That means they must turn over to the federal tax collector 33 cents out of the next $1 of taxable income they earn. Whereas 4.75% tax free would be all theirs to keep (Column C), in the 33% federal tax bracket they keep only 3.18% from a United States government obligation paying 4.75% which is taxable federally (D). They keep 2.68% from a Jumbo CD paying 4% taxable (E), and that doesn’t take into account the consequences of any state and local income taxes on bank interest. They keep 3.69% from a corporate bond paying 5.5%, which is also taxable, city, state, and federally (F). A taxable investment would have to pay 7.09% (G) to match the 4.75% this couple can earn tax free from long term, investment grade municipal bonds that are readily available as we go to press. So here are a husband and wife who, on the basis of arithmetic alone, could belong in municipal bonds. Do you? Study the table. Then you decide.

 

NEXT: Lesson 2 - The Tax-Free-Yield-To-Taxable-Yield Ratio