A recent article in the Wall Street Journal described a new investment trend: “Wealthy Americans eyeing potential tax increases are helping drive record amounts of money into municipal bond funds.”
It also went on to state that tax-free U.S. municipal (muni) bonds attracted an estimated $56.9 billion in net new money during the first six months of 2021 and that financial advisors are increasingly fielding questions about muni bonds and bond funds.
With these trends in mind, now is a good time to review some basics about tax-free (a.k.a., tax-exempt) investing.
¨ Reciprocal Immunity- For over 100 years, government entities do not tax each other’s investors. This means that the federal government does not tax earnings on debt securities issued by states and cities (e.g., muni bonds and bond funds) and states do not tax earnings on federal debt (e.g., Treasury securities).
¨ Tax Benefit- Tax-free investing means that investment earnings are exempt from federal income taxes. Muni bond and bond fund earnings are exempt from federal income taxes as are earnings from Roth IRAs (if specific rules are followed). In addition, most states and cities with income taxes waive taxes on investment earnings on their own muni securities (e.g., no tax for New Jersey residents with a New Jersey-issued bond).
¨ Roth IRA Rules- You can withdraw the earnings from a Roth IRA tax free if you have reached the age of 59½, and at least five years have passed since your Roth IRA account was opened. Investors can also consider converting a traditional IRA to a Roth IRA to avoid paying tax on withdrawals made in retirement. The amount that is converted is taxed as ordinary income, however, in the year that the conversion is made.
¨ It’s Not What You Earn, But What You Keep- Knowing how investments are taxed is an important factor when making investment decisions. Investors need to compare tax-free investment yields (e.g., muni bonds) to returns on similar, taxable investments (e.g., corporate or U.S. Treasury bonds) to determine which provides the greatest after-tax return after subtracting federal and/or state income taxes.
¨ Default Risk- Investors need to consider the risk involved with tax-free securities. The governing body that issues a muni bond can default just like any other debtor. Investors risk losing all or part of their of their principal and should always check the ratings of a bond for financial stability. Fortunately, federal aid has helped many states and cities with outstanding bonds weather the pandemic easier than originally thought.
¨ Marginal Tax Rates Matter- The term “marginal tax rate” refers to the tax rate paid on a person’s last dollar of income. Federal income tax rates currently range from 10% to 37%. Tax-free securities are especially beneficial for high marginal tax bracket investors because they allow them to keep more of an investment’s return versus having to pay federal and state taxes on taxable investments.
¨ There is an Easy Formula- Investors can easily compare tax-free and taxable investment yields by using the formula, below, to calculate the taxable equivalent yield for a tax-free investment. Once you have “done the math”, the next step is to compare formula-based yields to those currently available on fixed-income securities.
Taxable equivalent yield = tax-free yield ÷ (100% - marginal tax bracket %)
Example: Assume you are in the 22% tax bracket, and have an investment with a 4.0% tax-free yield. To get the equivalent taxable yield, divide 4.0% by .78 (100% - 22%). The taxable yield is 5.13%.
In the 24% tax bracket, the taxable equivalent of a 4% tax-free yield is 5.26% (4 ÷ (100% -24%) or .76).
In the 37% tax bracket, the taxable equivalent of a 4% tax-free yield is 6.06% (4 ÷ (100% -37%) or .63).
You can also use the What is My Tax-Equivalent Yield? calculator or the Bankrate Tax Equivalent Yield Calculator which use both federal and state income tax rates to calculate the tax-equivalent on tax-free securities.