Are Muni Bonds a Good Deal? Depends on Your Bracket

Muni bonds are a type of bond that is issued by a municipality. When you invest in this type of bond, you are not going to have to pay taxes on the interest that you receive. While this might sound like a fantastic deal, it really depends on what your tax bracket is. Here are a few things to consider about whether investing in muni bonds is a good deal for you.

How They Work

Municipalities issue this type of bond to the general public. Some examples of municipalities that issue these types of bonds are school systems, city governments, state governments and public airports. The municipalities will issue these bonds as a way to generate money for certain projects. The investors will provide them with a lump sum of money. The municipality will then pay regular interest payments to the investor over the life of the bond. At the end of the bond term, the investor can redeem the bond for the full amount that they invested. The interest that is received is not taxable at the federal level like most other bonds are. 

Tax Bracket Impact

Even though it might sound good to not have to pay taxes on these bonds, your tax bracket is going to play a large role in whether it is a good deal for you. The downside to these bonds is that the interest rates are lower than what you can get from a regular corporate bond. In order to determine if these bonds are any better than what you could get from a corporate bond, you have to look at the after-tax return of the corporate bonds and compare it to the return of the muni bonds. The higher tax bracket that you are in, the better these muni bonds are going to look. 

Example

Let's say that you want to invest in a muni bond and your tax bracket was 35%. The muni bond paid 4 percent annually. You also have the option to invest in a traditional corporate bond that pays 6% interest. The face value of the bond is $10,000. This means that you are going to receive interest payments of $400 from the muni bond. This $400 is tax-free. With the other bond, you are going to receive interest payments of $600. However, then you have to take taxes out of that amount. If your tax bracket was 35 percent, this means that you would have to pay $210 in taxes. This makes the amount of money that you get after taxes $390. This means that even though the interest rate was a full 2% less, the muni bond actually brought you more after-tax money to work with. 

If you were in a lower tax bracket, then the corporate bond would have been a better investment. You would not have had to pay so much in taxes and the corporate bond would have brought you more after-tax money.

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