Bonds are debt securities that are similar to IOUs. You are lending money to the government or a government entity when you purchase a bond, and in return, you are earning interest that the issuer promises to pay you. There are different types of bonds available for investment, and it is important to compare the taxable bonds to the tax-exempt, or municipal, bonds before investing your money.
It is obvious that the benefit behind municipal bonds is that they are exempt from local and state taxes. This provides the investor with the benefit of paying only federal taxes when the time comes; at the same time, the government entity is essentially provided a loan at a lower interest rate to provide for public services or projects such as public housing, sewage systems, highways, streets and schools. Taxable bonds, however, require the investor to pay state and local taxes and are generally offered to projects that to not benefit the overall public.
Rate of Return
Municipal, or tax-exempt bonds, offer a lower rate of return than the taxable bonds due because the investor is exempt from paying taxes. Depending on where you stand with the rest of your finances, this option may be beneficial for you. Taxable bonds offer a market rate level of return. Although this yield is higher than that of municipal bonds, it is important to do comparisons of the yields on a regular basis. This keeps you up to date with where your finances are and if you should make a different decision on what type of bond to invest in.
Net Taxable Income
Your taxable income can earn you more money or can result in less of a return on interest. Generally, if you are in the 28 percent federal income tax bracket or higher, you could make more money with a municipal bond in comparison to a taxable bond even though you are earning a lower yield.
The taxable-equivalent yield percentage is always going to be higher than the tax-free yield. This is because of the exemption of taxes with the municipal bond. The result depends on the state you live in, your net taxable income and your filing status when filing your tax return. Since the income tax bracket changes on an annual basis due to inflation, there is no set percentage for calculation. Do not let the higher percentage yield fool you into thinking that you are automatically making more of a return with the taxable bond than the tax-exempt bond. Once you find out the current yield rate, use this information to determine your rate of return. For instance, if you are offered a municipal bond with a yield of 1 percent, your equivalent could be 1.42 percent depending on your information. If this is the case and you find a taxable bond with 1.57 percent yield, you know that the taxable bond, in this case, is the better deal.
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