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Tax-Free Income From Municipal Bonds

written by: Brian Nelson•edited by: Rebecca Scudder•updated: 2/2/2009

Want to save money on your taxes? Looking for an investment that can provide you income with a huge tax savings? Try municipal bonds.

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    Munis Earn Tax-Free Interest

    Municipal Bonds, commonly known as Munis, are bonds that are issued by local, i.e. not federal, governments. Generally issued for municipal construction or other works, muni bonds are like all other bonds in that they pay a certain amount of interest for a certain amount of time until the principal is repaid.

    What makes municipal bonds special is that the interest they pay is tax-free!

    Usually, interest is taxed as normal income. That means that a bond paying 6% interest requires the investor to pay taxes on that 6% like it came from an employer in the form of a paycheck. But, municipal bonds are different.

    Since muni bonds are issued by another branch of government, they are not taxed by the federal government. Technically, the state could tax the interest, but most do not by choice in order to make their bonds more attractive investments to residents.

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    Taxable Equivalent Yield

    Since the investor does not pay taxes on the interest from a municipal bond, the interest earned is worth more to the investor’s net worth bottom line than the taxable interest received from regular corporate bonds. One way to calculate this extra value is the Taxable Equivalent Yield.

    The taxable equivalent yield of a bond is the interest rate a non-tax exempt bond would have to earn in order for the investor to end up with the same amount of money after taxes. In other words, since a 5% tax-free interest rate on a municipal bond would generate $50 of income which would not be reduced by taxes. A non-tax advantaged bond would earning 5% would also generate $50 of income, but then that amount would be reduced by the amount of taxes the investor would have to pay.

    For example, an investor in the 28% tax bracket would owe $14 in taxes for the $50 of income and thus would only net $36.

    But, if the investor earned approximately 7% (6.944%) on a regular taxable bond, then he would earn $70 in interest for which he would be required to pay approximately $20 ($19.60) for a net return of $50 just like the muni bond.

    To calculate the taxable equivalent yield of a muni bond, subtract the investor’s tax bracket from 1 and then divide the tax-free yield by that number.

    In our example above, the investor is in the 28% tax bracket, so 1 - .28 = .72 then we divide 5% by .72 or 0.05 / .72 to get 0.0694 or 6.94% which is the yield required from a taxable bond to equal the net return after taxes for that investor.

    Keep in mind that the taxable equivalent yield changes for different tax brackets which makes muni bonds more attractive for taxpayers in higher brackets than those in lower tax brackets.