Investments

July 6, 2017 / Timothy Grove

Tax-Free vs. Taxable Bonds: The Choice Is Not So Simple

As we all know, there are two basic types of bonds; those whose income is subject to federal and possibly state income taxes (such as Treasurys, corporate and foreign bonds) and those whose income is exempt from federal income tax and, possibly, state income tax (municipal bonds or “munis”).  Clients may wonder, understandably, why use taxable bonds at all when you can buy municipal bonds and have income that is tax free?

Good question, but like many things in life the choice is not that simple.  Due in large part to the fact that the market places a premium on munis due to their tax-exempt income, they will generally pay a lower yield than a taxable bond with a similar maturity and credit rating.  Remember that as bond prices rise, the current yield (which is the fixed coupon payment expressed as a percentage of the price paid for the bond) falls.  Since the market will have greater demand for a given muni bond than for an equivalent taxable bond, the price of the muni will be bid up and its yield will drop.  Conversely, the taxable bond must offer a higher yield to attract investors or it will “go begging” as investors favor the muni bond.

Remember that what matters is not the tax an investor pays but what he/she has left after the tax man takes his cut. Since, all else being equal, the muni bond will have a lower yield than a taxable bond, investors in lower marginal tax brackets (that is, a marginal tax rate below some threshold) are better off investing in the taxable bond since they will actually keep more income after the tax is paid than by investing in the muni bond, which pays tax-free income but at a lower yield.

So which is best for a given investor?  Unfortunately, some math is required to determine this.  An investor first needs to determine his or her marginal tax rate, also known as the marginal tax bracket or just tax bracket.  This is the rate at which the investor’s last dollar of income is taxed.  Your HFA Advisor can help you determine your marginal tax rate if you do not know it.

Once the investor’s marginal tax rate is known along with the current yield of the muni bond under consideration, the taxable equivalent yield can be determined. This is the yield that a taxable bond would have to pay in order for an investor at a given marginal tax bracket to net, after tax, the same income as the muni bond under consideration.  Put another way, this is the break-even yield where said investor would be indifferent between choosing the taxable bond or the muni.

The taxable equivalent yield is calculated using the following equation-

Taxable Equivalent Yield = Muni Bond Yield/(1 – Investor’s Marginal Tax Rate)

(Percentages are converted to decimals by dividing by 100% and then converted back to percentages by multiplying the result by 100%.)       

So for an investor in the 39% marginal tax bracket considering a muni bond yielding 4%, the rate that a taxable bond would have to pay in order for that investor to break even (or keep as much after paying the tax on the taxable bond income as he/she would get from the tax-free muni) is-

0.04/(1-0.39) = 0.04/0.61 = 0.0656 or 6.56%

For an investor in the 10% marginal tax bracket, the taxable equivalent yield on that same muni bond yielding 4% is-

0.04/(1-0.10) = 0.04/0.90 = 0.0444 or 4.44%

Since (holding other factors such as maturity and credit quality constant) it would be much easier to find a taxable bond yielding more than 4.44% than it would be to find one yielding over 6.56%, investors in lower marginal tax brackets generally keep more after tax than they would by using munis, and investors in higher marginal tax brackets generally come out ahead by using munis.

The equation given above can also be rearranged algebraically to determine the marginal tax rate at which an investor would be indifferent between a muni bond and a taxable bond, each with a known current yield (and equal in other respects such as maturity and credit quality)-

Break Even Marginal Tax Rate = 1 – (Muni Bond Yield/Taxable Bond Yield)

So in the first example given above, the yield of the muni bond is 4% and the yield of the taxable bond (the taxable equivalent yield) is 6.56%.  The unknown break even marginal tax rate is given by-

1 – (0.04/0.0656) = 1 – 0.6098 = 0.3902 or approximately 39%, which agrees with our original result.

And in the second example given above, the yield of the muni bond is 4% and the yield of the taxable bond (the taxable equivalent yield) is 4.44%.  The unknown breakeven marginal tax rate is given by-

1 – (0.04/0.0444) = 1 – 0.9009 = 0.0991 or approximately 10%, which also agrees with our original result.

Of course all that has been discussed so far applies only to taxable accounts.  But what about tax-sheltered retirement accounts?  Unfortunately in this case all bets are off, so to speak.  For employer plans such as 401(k) plans and for traditional IRAs, the money that is contributed is pre-tax, so this means that the full amount of all withdrawals in retirement is taxed as ordinary income.  This is regardless of whether the withdrawals are from principal, capital gains, or income, and it is also regardless of whether the income comes from muni bonds or taxable bonds.  For Roth IRAs, all withdrawals in retirement (again, regardless of the source) are tax-free, since the contributions are after tax.  So in retirement accounts it is nearly always advantageous to use taxable bonds regardless of the particular investor’s marginal tax bracket.

At HFA, our advisors perform a thorough, in-depth analysis of the tax situation of each of our clients to determine whether muni bonds or taxable bonds are best suited to that client’s individual goals and needs.

 

Sources

Investopedia – Tax Equivalent Yield

What are the Tax Benefits of Municipal Bonds

Investing in Bonds

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