That question may seem a little ridiculous, but there are times when getting a 4% return can put more money in your pocket that a 5% return does. How is that possible? Lower tax free or tax deferred returns may actually outperform higher yielding taxable investments.
Investors in the 25% tax bracket or higher are turning more and more to tax free municipal bonds for their secure investments. While the on going credit crunch has affected the muni bond market, demand is still high for these debt instruments – people who want a little extra yield look at muni bonds and in some instances may see them paying higher returns than bank certificates and U.S. Treasuries. Some municipal bonds are insured, too!
Figuring the tax equivalent yield of a muni bond is a real eye-opener. The tax equivalent yield of a muni bond equals the yield divided by the federal marginal tax rate. Here’s an example of the yield achieved by a 4% tax free bond owned by an individual in the 35% tax bracket:
Tax free municipal bond 4%
Divided by the federal marginal tax rate 1 - .035% = .65
Or .04% / .65%
The tax equivalent yield is: 6.2%
Some municipal bonds pay rates that are subject to the Alternative Minimum Tax (AMT). Some don’t. As a word of warning, be sure to consult your tax advisor to find out if tax free bonds are right for you in the first place and if you should avoid those with AMT.
Many state and local governments are struggling in the recession, so the default risk for municipal bonds has risen, too. Historically, however, the risk of a state or city going belly up has been incredibly low. No state has ever gone bankrupt, although a prominent American county once filed for bankruptcy (Orange County, CA, in 1994) and New York City and Cleveland nearly did in the 1970s.
Cities and states issue revenue bonds to raise money for infrastructure projects and general obligation bonds to raise fast capital. It’s almost inconceivable that a general obligation bond would default, as states and local governments could simply raise taxes to generate money owed to investors. Project specific revenue bonds may have more risk. However, you have the Obama administration ready to fund massive infrastructure improvements, and the White House has made it clear that much of it will be carried out on state and local levels.
The current credit rating and the long-term rating of the issuer are important as could be the avoidance of muni bonds with AMT. Be advised that this is in no way a complete discussion of yields and related issues. Please consult your tax advisor regarding your current situation.