Tax Free Municipal Bonds 

Why investing in municipal bonds is investing tax free?

Municipal bonds investing equals tax free investing. Investing in municipal bonds is considered investing tax free because ONLY the level of government issuing the bond can tax interest on those municipal bonds.

For example, interest on municipal bonds may be taxed by the municipal level (state and local governments) but not by the federal government.

Interest on municipal bonds issues of the federal government (T-bills, notes, and bonds) is taxed by the federal government but is exempt from taxation at the state and local levels.

Interest on issues of US territories is subject to a triple exemption (federal, state, and local).

Investors that purchase municipal bonds issued by the state in which they live often receive a special tax exemption; they may not be required to pay taxes on interest to the federal or state government.

For example, if you live in Los Angeles, CA and buy a California municipal bonds, the interest will not be subject to taxation on your federal or State of California return. However, if you live in Tempe, AZ and buy California municipal bonds, the interest will be exempt from taxation by the federal government but will be taxed by the State of Arizona. (Moral: Buy local!!!)

Things you need to know before investing tax free or investing in municipal bonds

It is not always better for everyone to invest in tax free investments. This is because, as a result of tax advantaged status of municipal bonds interest, municipalities generally pay lower interest rates than do corporate issuers.

Before investing in any tax free investments, investors should compare the interest AFTER tax of the tax free investment to a taxable investment. To do that, investors should be aware of the tax equivalent yield when assessing the merits of municipal bonds investment. Tax equivalent yield calculation will compare the yield AFTER tax of the 2 investments.

For example, assume you are in the 35% federal tax bracket and are considering tax free investing in California municipal bonds in a $10,000 investment yielding 4% or a taxable investment yielding 6%. At first glance, the taxable investment appears to be the more advantageous choice - earning $600 versus the tax free investment $400 earnings.

However, after taxes are considered, tax free investing would actually provide the better yield. That’s because the taxable investment would provide only $390 in income after federal income taxes are deducted. (We will have a handy calculator for finding your amounts here in the future. Stay tuned!)

In order to earn $400 after taxes, you would need a taxable investment yielding 6.2%. This is commonly referred to as the "taxable equivalent yield".

Generally, taxable equivalent yields rise with income tax brackets. In other words the higher your tax bracket, the more you need to earn on a taxable investment to match the tax free investments earnings on municipal bonds fund. Therefore, in general, investing tax free with municipal bonds is more appropriate for investors in high tax brackets, and is not suitable for investors in low tax brackets.

We recommend you consult your tax advisor before making a decision to invest tax free. Tax deferred, on the other hand, should always be taken advantage of when your goals allow for it.