Municipal Bonds: A Source of Tax-Free Income
There’s one readily available and legal source of untaxed income that we know of:
municipal bonds. These securities are issued by state and local governments, school
districts, hospitals and other public agencies to support community projects and
services. To permit these worthy endeavors to raise money economically, Uncle Sam
exempts the interest that they pay from federal income tax. And state governments
usually do the same for bonds issued within their borders.
As a result, these tax-free “munis” historically pay about 75%-90% of the interest that
you’d earn on a taxable bond of comparable maturity and credit quality. So, depending
on your tax bracket, munis actually may give you higher after-tax income.
To figure the equivalent taxable yield of a tax-free bond, divide its yield by one
minus your tax rate expressed as a decimal.
If you live in a high-tax state, this advantage can be even more dramatic. Suppose
that you pay an 8% state tax. Because you deduct state tax from your federal income,
your effective state tax is 5.20% (8% x .65), and your combined tax rate is 40.20%.
So you’d divide that 5% by .598 (1-.402) and get 8.36%. In that case, you’d prefer
the 5% muni issued in your state to any comparable taxable bond paying less than
Types of municipal bonds
According to their issuers and their terms, munis fall into several distinct categories.
General obligation bonds are backed by the full taxing power of the city or state
that issues them.
- Revenue bonds pay their coupons and repay their principal from the revenues of
the projects that they fund, which can be toll bridges, airports or other public
- Private activity bonds are issued in support of private projects, such as industrial
parks or shopping malls, intended to bring business to the community. Although income
from these bonds issued after August 1, 1986, is exempt from income tax, it is hit
by the alternative minimum tax when earned by investors subject to the AMT. This
threat tends to push the yields of these bonds up a bit, boosting their attraction
for investors not affected by the AMT.
- Zero-coupon municipal bonds are sold at a large discount from their face value
and pay no current interest. The investor instead receives the full face value at
maturity, with all the gain tax free.
- Prerefunded bonds. With the relatively low interest rates of the last few years,
some municipalities have issued bonds to pay for the redemption of older, higher-yielding
bonds on their call date. Until that time the money is usually parked in U.S. Treasury
securities. As a result, the prerefunded older munis carry an extra measure of safety.
As with other fixed-income securities, munis are subject to two distinct types of
risk: Interest rate risk refers to the fact that a bond loses value in the secondary
market when interest rates rise. Nobody will pay full price for a 5% bond when new
bonds are available that pay 6%. So, if you need to sell a bond in that situation,
you’ll have to accept a price that will give the buyer a competitive yield.
On the other hand, if interest rates fall, the value of your bonds will rise. Don’t
count your chickens, though. Most munis carry call provisions allowing the issuer
to redeem the bonds early at a specified date, usually with the payment of a call
Municipal bonds bought at a premium and held until maturity cannot create a capital loss.
Premiums must be amortized, but a loss is possible if the bond is sold before maturity.
Note that any loss that you take on the sale of a muni may be used to offset capital
gains plus up to $3,000 of ordinary income. Any gain, however, may be subject to
ordinary income tax (not the reduced capital gains rate).
Of course, if you hold a bond to maturity, interest rate risk is not an issue.
Credit risk refers to the possibility that the issuer will default on the timely
payment of interest and/or principal. Albeit a rare occurrence, we had the 1994
example of Orange County, California, to impress this possibility upon us.
Naturally, lower-rated issues carry higher yields, but of late the spread between
highquality and junk bonds has been little more than 1%. So it’s hardly worth accepting
the extra risk for the marginal boost in income.
As mentioned above, prerefunding can enhance the safety of a bond. More common,
however, is the use of insurance to upgrade an issue’s quality. Issuers purchase
insurance that guarantees payment of interest and principal in the event of a default.
Bonds thus covered automatically gain an S&P rating of AAA.
Another way to protect a tax-free portfolio is diversification. Bonds of different
types, from widespread issuers, and of varying maturities cushion the effect of
trouble in any one sector. Because most munis are issued in multiples of $5,000
or $25,000, such diversification is not possible for most individual investors.
For a tax-free portfolio of less than $500,000 or so, experts recommend investing
in either tax-free mutual funds or unit investment trusts. If tax-free income at
the yields available currently fits your financial needs, we’re ready to help you
build a working portfolio. And you won’t have to pick even one pocket.