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About Municipal Bonds

The Advantages of Tax Exemption

Under present federal income tax law, the interest income you receive from investing in municipal bonds is free from federal income taxes.* In most states, interest income received from securities issued by governmental units within the state is also exempt from state and local taxes. In addition, interest income from bonds issued by U.S. territories and possessions is exempt from federal, state and local income taxes in all 50 states.

One of the best ways to appreciate the tax-exempt advantage of a municipal security is to compare it to a comparable taxable investment. For example, assume you are in the 33% federal tax bracket, file a joint return and with your spouse, claim $210,000 in taxable income.

Now assume you have $30,000 to invest and you are considering two investment alternatives: a tax-exempt municipal bond yielding 5.0%, and a taxable corporate bond yielding 7.0%. Which investment will prove most advantageous in terms of after-tax income?

If you invest your money in the municipal bond, you’d earn $1,500 in interest (a 5.0% yield) and not pay any federal income taxes. The taxable bond investment, however, would provide you only $1,407 in income after federal income taxes had been deducted (a 4.7% yield).

*If you are subject to the Alternative Minimum Tax (AMT), you may have to include interest income from certain municipal securities in calculating your income tax.

 
Effect of Federal Income Taxes on Yields of Tax-Exempt and Taxable Instruments
  5.0% Tax-exempt Bond 7.0% Taxable Bond
Cash investment $30,000 $30,000
Interest $1,500 $2,100
Federal income tax in the 33% marginal tax bracket $0 $693
Net return $1,500 $1,407
Yield on investment after taxes 5.0% 4.7%

As you can see, the municipal bond would provide the better yield after taxes are taken into account. The tax-exempt bond yield advantage would be an even better investment if you accounted for state and local income taxes when calculating returns on the taxable bond investment.

To determine the yield you would need to earn from a taxable investment to equal the yield on a tax-exempt security, refer to the Tax-Free vs. Taxable Yield Comparison Calculator.

 

All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.