How municipal bonds work Tax-equivalent yields Good to know Wisconsin taxes
Tax-free income can be difficult to find, but municipal bonds are one of the most common sources.
Municipal bonds generally pay interest that is free from federal income tax and are issued by local and state municipalities. The tax-free nature of their income often makes municipal bonds attractive for investors in a higher tax bracket. You must account for the tax benefits of municipal bonds when comparing them to corporate bonds.
Tax equivalent yields are based on federal tax rates of 32%, 35%, and 37%.
For example, if your income puts you in the 35% tax bracket then a 4% municipal bond has a tax equivalent yield of 6.15%. That means you’d have to find a corporate bond paying better than 6.15% to compete with a 4% municipal bond.
Tax-equivalent yield = tax-free yield ÷ (1 − your federal tax rate)
The yield a taxable bond would need to pay to match a municipal bond, by federal tax bracket.
Tax-free yield32% bracket35% bracket37% bracket
3.00% municipal bond
4.00% municipal bond
5.00% municipal bond
Bars are drawn on a 0–9% scale. The highlighted 6.15% matches the example above. Federal tax only; state taxes and the 3.8% net investment income tax are not included.
| Tax-free yield | 32% bracket | 35% bracket | 37% bracket |
|---|---|---|---|
| 3.00% | 4.41% | 4.62% | 4.76% |
| 4.00% | 5.88% | 6.15% | 6.35% |
| 5.00% | 7.35% | 7.69% | 7.94% |
Please be advised that income from municipal securities is generally free from federal taxes and state taxes for residents of the issuing state. While the interest income is tax-free, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT). Investments in fixed-income securities are subject to market, interest rate, credit, and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in a decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and/or principal. This risk is heightened in lower-rated bonds. If sold prior to maturity, fixed-income securities are subject to market risk. All fixed-income investments may be worth less than their original cost upon redemption or maturity.
FOR WISCONSIN RESIDENTS
Wisconsin is an exception to the usual in-state rule. Wisconsin taxes most municipal bond interest, including interest on many bonds issued in Wisconsin; only certain bonds specifically exempted by state law are free from Wisconsin income tax. We’ll help you sort out which is which.
Also keep in mind that tax-exempt interest still counts when determining how much of your Social Security benefit is taxable and whether you pay higher Medicare premiums.
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Municipal bonds can be complicated. There are general obligation bonds, revenue bonds, pre-refunded bonds, bonds with sinking funds, insured bonds, Build America bonds, unrated bonds, and bonds subject to AMT.
General obligation bonds Revenue bonds Pre-refunded bonds Bonds with sinking funds Insured bonds Build America bonds Unrated bonds Bonds subject to AMT
BKM Wealth Management is a family team of fee-only, fiduciary financial advisors in Brookfield, Wisconsin. We’re here to help you navigate the complexity and create income for you in retirement. Please contact us to discuss your situation.
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We’ll help you weigh municipal bonds alongside the rest of your portfolio and tax picture.
The content on this page has been provided for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Since each person’s situation is different you should review your specific investment objectives, risk tolerance and liquidity needs with your financial, tax and legal professionals before selecting a suitable savings or investment strategy.
BKM Wealth Management does not offer legal advice.