Tax-Free Munis: A Great Deal for Some, Not Right for Others.

This week I’ll keep it short and offer two reminders about tax-free municipal bonds:

1. If you are in the highest tax bracket, tax-free muni bonds look better today than they have in a long time.

2. If you aren’t in the highest tax bracket, you need to do some math to understand whether they still make sense.

Calculating Tax-Equivalent Yield

Here is a chart from Tuesday showing the Treasury rates compared to the generic AA-rated municipal bond curve. TEY in the right column stands for tax-equivalent yield, and the number tells us the annual return you would need to receive on a taxable bond to get the same result at today’s highest federal tax rate (37% + a 3.8% ACA surtax, for a total of 40.8%).

Source: Data from the Bloomberg US General Obligation AA Muni Curve, the U.S. Department of the Treasury (treasury.gov), and Performance Trust

If you were considering bonds or CDs in your taxable account, and you are in this highest tax bracket, muni bonds are very much worth a look.

But Remember: Most Retirees Aren’t in the Highest Tax Bracket

It doesn’t matter if you have a $10,000,000 net worth. If you are married and your taxable income after deductions falls between $100,800 and $211,400, you are in the 22% tax bracket. If your taxable income is lower, your tax bracket is lower.

Here is a chart showing how tax-equivalent yields compare for each level of taxable income.

Source: Hartford Funds

The bond generating a tax-equivalent yield of 7.6% for someone with $770,000 of taxable income in the 40.8% bracket generates only a 5.92% tax-equivalent yield for someone in the 24% bracket and 5.11% for someone in the 12% bracket.

So, before you get too excited about the idea of tax-free income, do some tax planning, evaluate the relative credit risks, and figure out which bonds make the most sense for you.

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Disclaimer: This note isn’t intended as a recommendation to buy or sell munis. Muni bonds have default risk, and some are extremely risky. If you pay state income tax, that impacts the calculation. My goal is to show you where munis are today and remind you to do the math.

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Personal Note:

On Monday nights for the next few weeks, I get to coach lacrosse teams for my 6th- and 8th-graders. We’re playing indoors at Rice in their air-conditioned practice facility, and I never want to go back outside to another 105-degree field ever again.