Many investors wonder if they should buy tax free municipal bonds. The best way to analyze this is by comparing the income you would receive from the bonds both before and after taxes are considered. Let’s look at an example.
Suppose that you are considering buying a tax free municipal bond that yields 5% and you wonder what you would need to earn on a taxable bond with similar risk and maturity after federal taxes are considered to compare to the tax free yield of 5%. If you are in the 33% income tax bracket you would divide the yield of .05 by .67 (100% less 33%) and get the comparable after tax yield of 7.46%. You can check your math by taking the comparable after tax yield of 7.46% and reducing it by the amount of tax or 33% (2.46%) for an after tax interest of around 5%. This means after you have paid taxes on a taxable bond paying 7.46% interest if you are in the 33% federal tax bracket you would be left with around 5% therefore a taxable bond would need to yield over 7.46% to beat a tax free bond paying 5%. If you are in a lower tax bracket you would use the same calculation using your highest tax rate. The lower the tax rate the less likely it is that you would benefit from buying municipal bonds. If you are planning to hold the bonds for several years your likely future tax rate should be taken into account in making your decision.