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Municipal Bonds: Tax-Free Income

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Municipal bonds are investment securities offered by local governments and agencies, including cities, states, counties, public utilities, and public works.  In Colorado, perhaps the most well-known municipal bonds were those issued to help build Denver International Airport.

Municipal bonds take two forms: revenue bonds and general obligation bonds.  Interest and principal payments on general obligation bonds are met through the tax levies of the municipality issuing the bond.  Interest and principal payments on revenue bonds are usually met through the income generated by the project funded by the bonds.  A well-known project funded by revenue bonds is the RTD light-rail system.  Within these two categories, the types of bonds issued vary.  A few of the categories are zero-coupon bonds, housing bonds, taxable municipal bonds, pre-refunded bonds, and original-issue discount bonds.

The creation, rules, and characteristics of municipal bonds are complicated and beyond the scope of this blog post.  For the purposes of this blog, our focus is the special taxation properties of municipal bonds.  Interest payments made to bond holders are generally free from federal taxation.  In addition, if the bond holder is a resident of the state by which the bond is issued, the interest may also be free from state taxes.  These special tax provisions are the predominant reason that investors choose to purchase municipal bonds.

Consider the following: As a result of The American Taxpayer Relief Act of 2012, the top marginal tax rate has increased from 35% to 39.6%.  In addition, for residents of Colorado, the state income tax rate is 4.63%.  The new Medicare surtax is 3.8%.  As a result, the top wage earners in the state of Colorado pay a tax rate of 48%.  The impact of taxes becomes especially clear when comparing the after-tax yield of taxable bonds to the tax-free yield of municipal bonds.  The table below shows the yield a taxable bond must pay in order to match the after-tax yield of a municipal bond paying 4% interest.

Marginal Tax BracketAfter-Tax Yield
25%5.33%
35%6.15%
39.6%6.62%
Colorado 48%7.69%

In most cases, tax-free municipal bonds are most appropriate for non-retirement accounts, as the tax advantage is lost when used in tax-deferred accounts.  The three most common methods of investment are through purchasing individual issues of bonds, purchasing shares of a mutual fund, or purchasing exchange-traded funds (ETF).  The advisors at Wisdom Wealth Strategies are well-versed in the strategies surrounding municipal bonds.  Please reach out to us if we can be of service.

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