Perhaps you are thinking of adding bonds to your portfolio. Whether your potential investment is an individual bond or a bond mutual fund, you will need to be able to evaluate what the bond yields. But with so many different types of bonds, what factors should you consider in making such an evaluation?
The first step is to identify the kind of bond you are considering purchasing. Is the bond taxable or tax-free? The yield on a tax-free bond might be lower than that paid by a taxable bond. But is it? There is a need to look at it on a tax-equivalent basis to compare them accurately. By not doing so, you are, in a sense, comparing apples to oranges.
As a general rule, the interest on corporate bonds is taxable by local, state and federal governments. Interest on bonds issued by state and local governments is generally exempt from federal income tax. In addition, municipal bond interest might be exempt from state and local taxes as well if the bond was issued in that particular state.
Tax-free bonds are also called municipal bonds or munis. As the municipality has taxing authority and can generate revenue to pay bond holders, they are often considered safer than corporate bonds. Investors may accept a lower yield in exchange for a safer outcome. The difference in tax treatment will affect the yield as well.
How to determine which is right for you? It depends on your tax bracket. Usually the higher your tax bracket, the higher the yield you will receive on the municipal bond.
To calculate this, you will need to figure out the tax-equivalent yield. Its formula is the following: subtract your marginal tax rate from 1, then multiply the taxable bond’s yield by the result.
To calculate the taxable equivalent of a tax-free yield, subtract your marginal tax rate from 1, then divide the tax-free yield by the result. (Your marginal tax rate is the income tax rate at which the last dollar of income is taxed.) Consider the impact of state and local taxes as well.
So, if you decide to purchase muni bonds, are they always tax-free? As with all things taxes, not necessarily. The tax-exempt status applies to the interest paid on the bond. If the bond increases in value during the time you hold the bond, you will pay tax on the increase when the bond is sold. The same is true of a muni bond mutual fund. Any increases in value will generate taxable income when you sell the fund.
Depending on how the issuer of the bond uses the proceeds, the fund might be subject to federal tax. For example, if the bond finances a project that offers a substantial benefit to private interest, it is taxable at the federal level, unless specifically exempted. This is called a private-purpose bond.
Other type of bonds are agencies and GSEs (government-sponsored enterprises). These vary in tax status. Examples of these include Ginnie Mae, Fannie Mae and Freddie Mac. Before buying these types of bonds, verify the federal and state tax status.
The alternative minimum tax (AMT) might also come into play in certain situations. While the bond might be exempt from regular federal tax, it might be considered an income source when calculating the AMT. Your year-end 1099 is one source to find this information out at tax time.
Keep in mind that it provides you no current benefit to invest in muni bonds within your tax-deferred accounts, such as an IRA. IRA earnings are already tax deferred, so there is no reason to accept the lower return of a muni bond in exchange for the tax deferral of the IRA. In most circumstances, IRA withdrawals will then be taxed upon distribution.
Remember, the investment return that matters is the return left after taxes have been paid. Be sure to discuss your unique situation with your tax or financial adviser.