TO FIGURE OUT whether it makes sense to buy taxable bonds or tax-free municipal bonds, you first need to find out your marginal federal and state income tax brackets. Let’s say you are in the 32% federal income tax bracket and a 7% state tax bracket. Meanwhile, suppose you are choosing between a muni bond from your own state that yields 3.05% and a corporate bond that pays 4.95%. Both have similar credit quality and duration.
Which is the best bet, given your tax situation? You would need to calculate the tax-equivalent yield for the muni bond. To that end, you would take your tax brackets (32% and 7%), convert them to decimals (0.32 and 0.07), add them together (0.39) and then subtract that figure from 1. You would then divide the resulting number into the muni’s yield.
That would mean dividing the muni’s 3.05% yield by 0.61. That gives you a tax-equivalent yield of 5%, which is more than the 4.95% yield on the corporate bond. Result: The municipal bond is the better deal. Or maybe not. You might also consider an alternative strategy: buying taxable bonds in a retirement account, which we discuss next.
If you need help calculating tax-equivalent yields, try an online calculator, such as those offered by Bankrate.com and Fidelity.com. These calculators can generate slightly different results, depending on each calculator’s embedded assumptions. You can also learn more about the math involved in the chapter on investment math.
Bear in mind that your tax bracket can change from year to year. Even if munis make financial sense today, they may not make sense when you retire. At that juncture, you might pocket more income by buying taxable bonds, even after paying the resulting tax bill.
Next: Munis vs. Taxables (II)
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