At this point, many readers can rightly point out that nobody pays the top rate because of the various income deductions and tax loopholes that exist. But it is a graduated rate, and a portion of the investor's income may well be taxed at or near their highest graduated rate. Therefore, the highest rate can be used for comparing taxable and tax-exempt income investments.
With municipal bond rates being so low for so long, and with the 15% cap on taxes on qualified dividends, many investors have avoided municipal bonds for years. In the low-rate environment, with long-term rates declining for many years, some yield-hungry investors have decided to take additional risk by focusing on preferred shares or trust preferred shares for income.
So the main factor in deciding between taxable or tax-free income paper -- of the tax on dividends is reinstated -- is your tolerance for risk.
Taxable or Tax-free?
For investors who wish to stick with higher-rated bonds, here's a quick comparison, illustrating the tax implications, the dismal overall rate environment, and the market pressure on municipal bond prices. Keep in mind that these are not investment recommendations. They are just examples to provide food for thought, and it would be a good idea to have detailed discussions with your broker or investment adviser about various was to invest for current income.
A newly issued New York Triborough Bridge and Tunnel Authority bond that settles on Thursday and matures on November 15, 2023, has a coupon of 5.00%, with a yield of 2.26%, through its optional redemption date of November 15, 2022. The bond is rated Aa3 by Moody's Investors Service and AA- by Standard & Poor's. While that may not seem to be a very impressive yield at first, the interest is exempt from federal, New York State and New York City income taxes.
In case you're wondering why the yield is so low relative to the coupon, it is because many municipal bonds are issued with above-market coupons and huge premiums. If rates move up sharply and the market price of the bond declines below par -- known as a "de minimus" situation -- some investors are subject to federal income taxes on the otherwise tax-exempt dividend.
If you divide that 2.26% yield by one minus your combined marginal tax rate, you have the taxable equivalent yield, which can be used for comparison. Going to extremes, if you are in the highest federal tax bracket, with your investment income also subject to the new 3.8% Medicare tax for a combined 43.4% federal rate, your taxable equivalent yield on the Triborough Bridge and Tunnel Authority paper is 3.99%.
If you live in New York State, are married, filing jointly, and earn between $300,001 and $2 million, your highest state income tax rate for 2012 is 6.85%, and your taxable equivalent yield is 4.54%. Using this rate for the taxable equivalent calculation is not as extreme as it may look, because the state income tax rate is 6.45% for couples earning from $40,001 to $150,000, and 6.65% for those earning from $150,001 to $300,000.