Pros & Cons of Tax-Free Municipal Bonds

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Municipal bonds can provide substantial savings to high-bracket taxpayers. These bonds, issued by state and local governments, help finance projects such as road repairs and new schools. If you're a top-bracket earner in a city and state that both levy income taxes, a local triple-tax-free municipal bond can shield up to half of the interest it generates, and maybe even more. But beware -- municipal bonds are not for everyone.

Pro: Save on Taxes

Almost all municipal bonds are free from federal income taxes. State laws determine whether municipal bonds are completely tax-free, and you save on state and municipal taxes only if you live in the issuer’s locale.

For example, New York City imposes a top income tax of 3.68 percent, and New York State levies 9 percent on top earners. Add a top federal tax rate of 39.6 percent, and Big Apple big earners are on the hook for more 52 percent. A triple-tax-free New York City municipal bond lets these investors keep 100 percent of the bond interest, but only if they live in New York City.

Pro: Select Your Level of Risk

Some municipal bonds default. Most do not, and you can avoid the riskier ones by insisting on top-rated, insured general obligation bonds. The bond issuer pledges its full faith and credit to make timely principal and interest payments, while a third-party insurer stands ready to back up that promise.

An independent bond rating agency should give a top rating to your prospective purchase if you want to minimize risk. If you want a higher return and are willing to take on more risk, you can consider lower-rated, uninsured municipal bonds that are backed only by revenue streams or tax assessments.

Con: More Defaults, Less Insurance

Bond insurers got burned in 2007 by the subprime mortgage crisis, and most have since folded. In 2011, only 5.5 percent of municipal bonds carried insurance, according to Thomson Reuters. Too bad, because the Federal Reserve disclosed in 2012 that municipal bond defaults in the past 40 years were 36 times more numerous than previously reported. The bottom line: Municipal bonds are riskier than thought, and insured bonds are difficult to find.

Con: Must Do Arithmetic

You can compute the taxable equivalent of a tax-free bond. Calculate the “reciprocal rate” of a municipal bond by subtracting your combined tax rate from 1 and dividing into the municipal bond interest rate. For example, our New York City dweller in the 52 percent combined bracket has a reciprocal rate of 48 percent. A tax-free municipal bond paying 4 percent is equivalent to a taxable bond yielding 8.33 percent.

But if you are in a combined 35 percent bracket, you need earn only 6.15 percent taxable to receive an equivalent after-tax return. You might get a higher yield from a corporate bond or preferred stock. A little math will prevent you from overestimating the value of a municipal bond.