Muni Bonds: Principal Considerations

Investors who seek income exempt from federal income, federal alternative minimum, and Idaho state income taxes, may find that Idaho municipal bonds suit their needs. Potential options include purchasing a single municipal bond, often held to maturity, or investing in a municipal bond mutual fund. Not every investor will benefit from the tax-exemption, however. Those who invest primarily through a tax-advantaged account, such as an IRA, 401(k), or other tax-deferred retirement account, will not realize the tax benefits of municipal bonds but may find them otherwise suitable as a relatively low-risk income stream. Held in taxable accounts, municipal securities have clear advantages, particularly for investors in higher tax brackets.

It is relatively straightforward to determine the effect of tax-exempt status on returns by using the following formula to compute an investment's "tax-equivalent yield":

Tax Equivalent Yield = Tax-Free Yield
(1 – investor's federal tax bracket %)

This formula helps determine whether the yield on a tax-free investment is higher than the after-tax yield of a non-exempt investment. To illustrate, given tax brackets of 25%, 28%, and 35%, and a hypothetical tax-free yield of 3.00%, a taxable investment would need to provide an even higher yield in order to deliver a higher actual return.

Tax-Free Yield Tax Bracket Tax Equivalent Yield
3.00% 25% 4.00%
3.00% 28% 4.17%
3.00% 35% 4.62%

A higher tax bracket lowers the denominator of the equation, producing a higher tax-equivalent yield. Conversely, investors in lower tax brackets may find better yields in taxable alternatives.

The information and example above are provided for illustrative and educational purposes. They are not intended to be, and should not be construed as, legal or tax advice. Investing in municipal bonds for the purpose of generating tax-exempt income may not be appropriate for all investors. The municipal bond market can be volatile and significantly affected by changes in interest rates; adverse tax, legislative or political changes; and the financial condition of the issuers of municipal securities.

Tax laws vary from state to state. Any particular state's laws may affect the applicability, accuracy and completeness of the information and examples above. Please consult an attorney or tax professional regarding your specific legal or tax situation.