When investing in municipal bonds, it’s important to keep in mind that the yields are generally not an across the board comparison to CD yields or US Treasury yields. Let’s go through how each investment is taxed:
CD Yields = Taxable at both the state and federal level
US Treasury Yields = Taxable at the federal level, but tax exempt at the state level
Municipal bonds outside of the state where you live = Taxable at the state level, but tax exempt at the federal level
Municipal bonds inside the state where you live = Tax exempt at both the state and federal level
Naturally, talk to a CPA and a financial advisor first to assess your own situation, but I’m going to illustrate how to get an “apples for apples” comparison of these investments. For now, I’m going to ignore inflation and local taxes. I’m in Denver so we’ll use Colorado for an example. Our state income tax rate here is 4.63% – I know, this is a low state tax rate, and no, I’m afraid we’re not accepting applicants at this time. We’ll assume that someone is in the 25% federal tax bracket. Let me show you how each of these investments above could result in the same yield when I put it in an after tax yield for a Colorado resident (and to note, these are not really current yields, it’s just a hypothetical example to show the math):
CD Yield = 5.68% … after taxes it would be 5.68% x (1 – (25% + 4.63%) = 4.00%
US Treasury Yield = 5.33% … after taxes it would be 5.33% x (1 – 25%) = 4.00% (no state taxes, just federal)
Wisconsin Municipal Bond = 4.19% … after taxes it would be 4.19% x (1 – 4.63%) = 4.00% (no federal taxes, just state)
Colorado Municipal Bond = 4.00% … after taxes it would 4.00% (no federal or state taxes)
With each of these yields, the same dollar amount ends up in your pocket when taxes are taken out (or not taken out). This also illustrates why it may make sense when buying municipal bonds to look outside of your state. On the surface, one may think to invest only in the municipal bonds inside your state since they’re double tax exempt. But depending on your state’s tax rate and municipal bond offers outside of it, even after paying state taxes you may end up with more yield in your pocket investing outside.
Another way to look at it is that if you have a CD, what yield on a municipal bond would you need to get the same amount in your pocket? If you have a 3% CD the municipal bond equivalent yield would be:
3% x (1 – (25% + 4.63%)] = 3% x 0.7037 = 2.11%
To get the same yield “in your pocket”, investing in a municipal bond may not require you to reach out for as much yield because of the effects of taxation. Yet another way to look at it is that if you have a municipal bond, what would be the “CD equivalent yield”? Let’s assume a 4.5% municipal bond. This is how you’d figure it out:
4.5%/(1 – (25% + 4.63%)] = 4.5%/0.7037 = 6.39%
In other words, if you had a 4.5% municipal bond you would end up with the same yield “in your pocket” as a 6.39% CD (again, I’m assuming for a Colorado tax rate).
Naturally the thing that I’m not speaking of is that bonds also have with them price fluctuation and default risk and are not FDIC insured. Comparing CDs and municipal bonds is not itself an “apples for apples” comparison, but this is more to get yield quotes into the same relative numbers after taxation.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. CD rates are FDIC Insured and offer a fixed rate of return if held to maturity.