Posted by Karen Munoz, EA

Understanding Municipal Bond Funds and its Taxation

Understanding Municipal Bond Funds and its Taxation

When a city, state, or county raises funding for state projects by issuing debt security, it is called municipal bonds. Common projects under such categories are road construction, water, public buildings, etc. A municipal bond stands out as an excellent addition to a taxable account since part or all of the funds' income can be tax-exempt, unlike a series of other bond holdings. 

This article sheds light on various things one should know about municipal bonds alongside taxation. 

Understanding Municipal Bond Funds

A bond is generally defined as a debt obligation like a loan that entities issue. The entity issuing such bonds might be a government body, a corporation, etc. Also known as munis, municipal bonds are a type of bond issued by the agencies of the government or its municipalities. 

Buying any government bond in America that is not from the federal treasury department will likely be a municipal bond. For instance, it could be from the county, state, city, or public utility.

The reason behind such debt obligation is to raise funds to power local projects like the construction of parks, highways, schools, etc. Funds from municipal bonds are classified as mutual funds with primary investment in municipal bonds. 

Taxation of Municipal Bond Funds  

With municipal bond funds, investors get tax-exempt interest free from income taxes (federal). The income might also be free from local and state income taxes for investors that live in issuing locality or state. 

For instance, a Hawaii bond might be triple tax-free. In other words, the bond might be exempt from local, state, and federal taxes as long as the investor lives and pays taxes in Hawaii. As a result, municipal bond funds are usually called tax-exempt or tax-free investments. 

Who Qualifies for Investment in Municipal Bond funds?

Investors interested in yields that are above what is available at the money market funds should consider the use of municipal bond funds. It provides an opportunity for tax-free income, an incentive for people in the higher tax bracket but wants to bring down their tax burden. 

Municipal bonds produce lower yields compared to other available bonds, like bonds coming from a corporation. However, it might be higher when compared to a similar federal treasury bond. Although, when you compare municipal bond funds to other corporate bonds with higher yields, the tax benefits sometimes compensate for the reduced yield. 

Estimating Tax-Equivalent Yields 

People who want to determine if a municipal bond fund is an appropriate investment are via the "tax-equivalent yield" approach. 

For instance, when you consider a taxable bond like a corporate bond that pays 5% might appear attractive initially to an interested investor that can buy a tax-free municipal bond that pays 4%. For one, however, to determine the best bond, the investor needs to estimate the tax-equivalent yield. 

We define the tax-equivalent yield as the pre-tax yield, a payment from the taxable bond for it to be the same as municipal bond yield tax-free. 

In calculating it, you will divide the yield from municipal bonds (tax-free) by one; and remove it from the investor's tax rate. For an investor in the 25% marginal tax bracket, for instance, who is considering a municipal bond paying 5%, the calculation is as follows:

Equivalent Tax Yield: 0.05/ (1 – 0.25) = 6.67%

This estimation shows that the income tax savings from using the tax-free municipal bonds can be in the same category with a taxable bond earning 6.67%. If the taxable bond yield is not up to 6.67%, it makes the municipal bond a better option for an investor that wants the best income.



Karen Munoz, EA
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