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.
Taxable Vs Non-Taxable Bonds
The obvious 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 issuer, often a 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. However, not all municipal bonds are issued by state or local governments. School districts, for example, sometimes issue tax-free non-government securities.
Taxable bonds are generally issued by corporations to raise money for expansion or general corporate purposes, rather than for projects that benefit the overall public. Unlike most municipal bonds, taxable bonds require the investor to pay state and local taxes on all interest payments.
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.
When comparing taxable vs non-taxable bonds, understand that the stated taxable yield will almost always be higher than the yield on tax-free securities. However, 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. Remember to factor in the exemption of taxes when comparing taxable bonds vs municipal bonds. Depending on the state you live in, your net taxable income and your filing status when filing your tax return, the taxable-equivalent yield of your tax-free bond can be much higher. Since the income tax bracket changes on an annual basis due to inflation, there is no set percentage for this calculation.
Once you find out the current yield rate, use this information to determine your rate of return using a municipal bond vs corporate bond calculator. 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 1.35 percent yield, you know that the non-taxable bond, in this case, is the better deal.
Tax-Free Bond Funds Vs Taxable Bond Funds
The same principles that apply when comparing taxable bonds vs municipal bonds apply to mutual funds as well. When comparing yields between funds, be sure to calculate a taxable-equivalent yield for a municipal bond fund before tossing it out for having a lower yield than a taxable bond fund.
- Jupiterimages/Photos.com/Getty Images