I wanted to share this article with you even though it is one year out of date because many of the principles he is talking about might be relevant to you. I tend to be an advocate of the 40% munis and 60 percent dividend bearing stocks because often you will pay hefty taxes trying to move money around too much through capital Gains taxes. However, as we all know taxes can change over the years so being aware of whatever tax changes occur is also important in figuring out a long term strategy that makes sense ongoing in all our lives.
Marc Prosser
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I talk about bonds when almost everyone else talks about stocks.
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Are Municipal Bonds Currently A Good Investment?
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Interest Rates (Photo credit: 401(K) 2013)
The short answer is probably not. Certificates of deposit
(CDs) are safer and have a major yield advantage, even after factoring
in the tax benefits of municipal bonds.
There are two main reasons that investors like to buy municipal bonds:
The income they produce is generally not taxable, and they are
perceived to be super-safe investments. Let’s explore these reasons more
closely to see if they are valid.
When rates are low, the tax advantage is not very large.
Nobody likes the idea of having to pay taxes, and most
municipal bonds provide a way to receive income free from federal, state
and local taxes. However, the tax advantage for municipal bonds is
smaller than most people think. First of all, most tools for estimating
the tax benefits of owning municipal bonds provide inaccurate results
that overestimate the benefits. They ignore the fact that there is a
difference between your marginal tax rate and your effective tax rate.
Let’s say your family files a joint return and will make $85,000 in
2013. Your marginal federal tax bracket for 2013 is 25 percent. However,
you will not pay 25 percent on all of your income. Instead, you will
pay a 10 percent rate on the first $17,850, then 15 percent on then next
$54,650, and finally 25 percent on the last $12,500. It doesn’t take a
math genius to figure out that your effective tax rate will be closer to
15 percent. However, most tools will use the marginal rate of your
highest tax bracket rather than your effective tax rate. In the example,
most benefits calculators will overestimate the tax benefit by 40
percent.
This is not to say that the tax benefit is not important, particularly if you live in a place like New York
where there both city and state taxes which can be avoided by buying
the right municipal bonds. However, the absolute value of the benefit is
not very high when interest rates are low. Only two years ago, at the
beginning of 2011, one could buy a twenty year AA-rated municipal bond
with a yield of 5.25 percent. Now, the yield on such a bond is only
around 3.75 percent, down about a third. Yields on shorter-duration
municipal bonds are even lower.
Let’s say your effective tax rate including federal, state
and local income taxes is 25 percent. If you buy a municipal bond that
yields 6 percent, then it would be the equivalent of a taxable yield of 8
percent. Put another way, you would be earning an extra 2 percent
because of the tax benefits. However, 10-year AA-rated municipal bonds
are not earning close to 6 percent. They are earning around 2 percent,
which is the taxable equivalent of 2.5 percent. The benefit is only half
a percent in terms of extra return. Not very much. In this case the
idea of not paying taxes is more powerful than the actual benefit.
How are CDs and municipal bonds taxed differently? Click here.
Investment grade municipal bonds are very safe, but FDIC-insured CDs are safer.
When you get a CD from a U.S. bank, your money is federally
insured up to $250,000. The federal government is basically
guaranteeing that you will receive your full deposit and earned interest
back. Municipal bonds do not carry this federal guarantee. While
municipal bonds have a very low default rate, they do sometimes default.
In 2012, four investment grade bond issues defaulted, out of the
approximately 10,000 issues rated by Standard & Poor’s. While the
number represented is less than 0.1 percent, defaults did occur. As CDs
are safer than bonds, the logical move would be to buy CDs instead of
municipal bonds if the CDs provided the same or a higher after-tax
return.
Let’s Take A Look:
|
Maturity
|
Yield On AAA Rated Municipal Bonds*
|
Taxable Equivalent Yield (based on an effective tax rate of 25% )
|
Top Yields From Learn Bond’s CD Table**
|
|
1 Year
|
0.20
|
0.25%
|
1.05%
|
|
3 Year
|
0.48
|
0.60%
|
1.36%
|
|
5 Year
|
.88
|
1.10%
|
1.70%
|
* Data from Municipal Market Advisors
** Bank names and more rates available here.
As you can see, CD yields after factoring in the tax benefits for a middle class to wealthy family are much higher than municipal bonds. For a five-year maturity which offers the smallest yield difference, the yield advantage is still six-tenths of a percent.
To see a list of top yielding CD’s go here.
