Should I Invest In Municipal Bonds?
Municipal bonds are a unique investment vehicle that investors should know about. The main reason to know about them, is they have unique tax advantages that can help investors both in retirement as well as getting to retirement.
To be classified as a municipal bond, they must be issued by and on behalf of a local governement or governmental authority. Some examples of government bodies that may issue municipal bonds are school districts, city governments, and state governements to name just a couple. A federal governmental body cannot issue bonds classified as municipal bonds however.
So what kind of advantages do municipal bonds have? The primary attraction to municipal bonds is the fact that they are generally tax free from federal income taxes. We say "generally" because there are certain municipal bonds that are taxable such as ones called "Build America" bonds. But by and large, municipal bonds are not taxed by the federal income tax.
As for state taxes, municipal bonds are state income tax free as long as they are purchased from a government or authority from the same state in which you live or are domiciled. If you purchase municipal bonds from outside of your state, then you will have to pay state income taxes on income received from the bond.
Are Municipal Bonds Right For Me?
The question people want to know is,"Should I buy municipal bonds?" Clearly, with these tax advantages, these bonds are very attractive to investors. Corporate and federal bond income is taxed at your normal income tax rate. Therefore, when held outside of a tax advantaged account such as an IRA, all else being equal, a municipal bond yield with an equivalent yield to maturity as a treasury or a corporate bond, will be more attractive from a purely yield of rate of return point of view.
In conclusion, municipal bonds can be useful in any stage of the retirement lifecycle. Those stages are the early working years, later working years, and retirement. Muncipal bonds can be great because tehy offer the stability of a governmental body that receives tax income in order to pay back the bond. Generally speaking, investments such as these pose less risk than bonds from private companies or enterprises...although this is only a general statement and not always true.
If you live in a state that doesn't have any state income taxes, or their rate is zero in other words, then you could buy a municipal bond from any state an the income from the bond would be tax free. One can quickly see how this is attractive to anyone, but especially attractive to someone living in retirement. There's a level of stability provided by muncipal bonds as well as tax free income that makes the tax equivalent yield attractive when compared to a taxable yield provided by competing investments.
Before buying a municipal bond, be sure to check its financial strength rating and that you will be fairly compensated for the risk. Not all municipal bonds fall on the same risk and financial strength spectrum so talk to a fixed income expert to guide you. Also, be sure to understand the difference between the yield to maturity and the coupon rate of the bond. It is paramount to understand this difference and its useful to use a yield to maturity calculator in order to do that.
Tax Equivalent Yield
The tax equivalent yield of a municipal bond is a term used to describe the rate of return that a municipal bond would get if income from the bond were taxable. In other words, its the higher rate of return a municipal bond would need to get if it were taxable, in order to equal its tax free yield to maturity.
It's important to know so that a person can compare a municipal bonds yield to maturity to a different type of bond's yield to maturity, such as a corporate bond.
Here's an example, if Joe bought a muncipal bond that had a yield to maturity of 4 percent and he was contemplating a corporate bond with a yield of 5 percent, which one should he purchase? To solve this, we need to know what Joe's marginal tax rate is. Let's say he is in the 25 percent tax bracket. In this example, we would take 4 percent and divide it by (1 - Tax Rate) and this would calculate a 5.33 precent tax equivalent yield for the municipal bond. This means that the municipal bond provides a better rate of return than the corporate bond before tax. Here is the tax equivalent yield formula:
TAX EQUIVALENT YIELD = Muni Yield to Maturity / (1 - Marginal Tax Rate)
Municipal bonds may or may not be right for you. If you like to live on the edge, then municipal bonds won't satisfy that appetite. But if you are looking for investments that provide tax free income, with generaly less risk than other investments, then municipal bonds may be for you. This may be especially attractive in retirement. There are still caveats to investing in municipal bonds such as understanding yield to worst and whether a bond is callable. Regardless, municipal bonds may provide a great opportunity for you.
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