All Bonds issued by the US Treasury and many Municipal Obligations carry the advantage of tax exemption.
Interest payments on US Treasury Bonds are exempt from state and local taxation, whereas interest on (most*) state and local Bonds is exempt from Federal taxation. In addition, many state and local Bonds are locally exempt as well. Typically, investors in higher tax brackets can reap benefit from owning these tax-advantaged bonds. It is important to note that only interest payments (not capital gains) receive exemptions, and, even they may be subject to the Alternative Minimum Tax (AMT).
An investor interested in purchasing a Municipal Bond, for instance, should compare the promised yield on that security with that of a comparable taxable Bond.
The following general formula can be used to determine what yield a taxable
bond (such as a Corporate
Bond) would need to compete with a Municipal Bond for your tax
bracket.
EQUIVALENT YIELD FORMULA
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Equivalent Taxable Yield = (Tax Exempt Yield) / (1-Your
Marginal Tax Rate)
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For example (Yields are hypothetical):
Tax Free Yield on Municipal Bond X = 5.00%
Tax Bracket = 28.00% (assume state and federal combined)
Equivalent Taxable Yield = 5.00% / (1-. 28)
Equivalent Taxable Yield = 6.944%
For this investor a tax-free yield of 5.00% is equivalent to a fully taxable yield of 6.944%.
The above formula only holds for the coupon interest. If a Municipal or Treasury
Bond is purchased at a Discount
(priced less than par),
there will likely be capital gains at maturity
that are subject to taxation**.
*Taxable Municipal Bonds include those deemed not to provide
significant public benefit such as bonds to finance local sports
facilities.
**Please remember that these are all general rules and tax
specialists should be consulted over specific issues. The
Bond Market Association provides additional information.
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