NEW YORK ( TheStreet) -- Have you always wondered whether it makes sense for you to buy municipal bonds? The following calculations should help you figure it out.The basic question is: Is your after-tax return on taxable bonds better than your tax-free return with munis? If you live in a state without an income tax, you've got it easy.
No State Income Tax in Your Equation
If You Pay State Income TaxIf you live in a state with income tax, the process of choosing between municipal and taxable bonds is a little more complicated. In general, you don't pay state tax on munis issued in your state, and Treasuries are not taxed at the state level. The chief benefit of buying munis outside of your state is diversification. A national muni bond fund is going to be more diverse than a single-state fund. But if you're in a big state, you probably don't need to look beyond your borders in order to diversify. There are four main comparisons you might make:
1. State-Issued Municipal Bonds vs. Treasury BondsThe simple calculation described above is all you need to do. Because neither investment generates income that's taxable at the state level, it's as if you lived in a state without an income tax.
2. Outside-State Issued Municipal Bonds vs. Treasury BondsThe muni yield is taxable at the state level, the Treasury yield isn't. So to do an apples-to-apples comparison, you need to adjust the muni yield for state taxes and the Treasury yield for federal taxes. If you don't deduct your state tax payment from your federal tax bill, you can simply lower the Treasury yield by your federal tax rate and the muni yield by the state tax rate. If you do deduct, lower the muni yield by your effective state tax rate, which is your state tax rate adjusted downward by your federal rate. Example: Your federal rate is 28% and your state rate is 6%. Your effective state tax rate is 6% lowered by 28%, or 6% - (0.28 x 6%) = 6% - 1.68% = 4.32%. So you'd lower the Treasury yield by 28% and the muni yield by 4.32%, then compare the two.
3. State-Issued Municipal Bonds vs. Corporate Bonds (or Agency Bonds)The munis are totally tax-free, the other bonds are taxable at all levels. You need to adjust the taxable yield for all taxes. If you don't deduct your state taxes from your federal taxes, then lower the taxable yield by the sum of your federal and state rates. If you do deduct, lower it by the sum of your federal and effective state rates. If you're comparing munis to a U.S. government bond fund, which contains both Treasury and agency bonds, only a portion of your earnings will be subject to state income tax. Unless a fund observes limits on how much of its assets it will invest in non-Treasury bonds, you can't know for sure how it's going to affect your tax bill, but the fund company should be able to tell you how the manager has allocated the fund's assets historically. Apply this calculation to the portion of the fund's dividend you expect to be state taxable, adjusting the rest for federal taxes only. Say, for example, a fund historically has paid out income 25% of which is tax-free at the state level and 75% of which is fully taxable. With a federal rate of 28% and a combined federal and state rate of 4.32%, you'd need to lower the fund's yield by 31.2% to do a fair comparison with munis issued in your state. Here's the math:
(0.28 x 0.25) + ((0.28 +0.043) x 0.75) =
0.07 + (0.323 x 0.75) =
0.07 + 0.24225 =
0.31225 = 31.2%