What it means
A municipal bond is a loan to a state, city or other public body, often to pay for schools, roads or water systems. In the United States, interest on most of these bonds is exempt from federal income tax, and many states also exempt interest on bonds issued within their own borders.
The result is a triple tax-free bond when a resident of a state buys a bond issued by that state or by a city within it, and that city also has a local income tax. Federal, state and local tax are all avoided on the interest, which is the best outcome for the investor.
Because the interest is not taxed, the bond can pay a lower rate than a comparable taxable bond and still leave the investor better off after tax. The higher a person's combined tax rate, the more valuable the exemption is.
Investors in low tax brackets often gain little from it. To compare fairly, investors convert the tax-free yield into a tax-equivalent yield, which is the return a taxable bond would need to pay to leave the same amount after tax.
This is the key calculation, and it should use the investor's own combined marginal rate (the rate on the next dollar of income). There are important limits.
Capital gains from selling the bond at a profit are usually taxable, some bonds called private activity bonds can be subject to the alternative minimum tax, and out-of-state bonds typically lose the state exemption. Bonds issued by some US territories are exempt from tax in every state, so they can be triple tax-free for any resident.
In practice
Real-world examples.
Example
A retired teacher living in a city with its own income tax buys a bond issued by her own state's water authority. The interest escapes federal, state and city income tax, so the full coupon reaches her bank account.
Example
A doctor in a high tax bracket holds $500,000 of bonds from his home state. He compares their yield with a corporate bond by calculating the tax-equivalent yield, and finds the municipal bonds come out ahead. He also checks the issuer's credit rating, because a tax break does not make a weak borrower safe.
Example
A financial adviser shows a young client in a low tax bracket that a triple tax-free bond is not worth the lower yield. The client keeps a taxable bond fund instead, because the exemption would save only a few dollars.
Formula
Calculation
Tax-equivalent yield = Tax-free yield / (1 - Combined marginal tax rate)
An investor in a high-tax city has a combined marginal rate of 40%, made up of federal, state and local income tax. She is offered a triple tax-free bond yielding 4.5%.
Tax-equivalent yield = 4.5% / (1 - 0.40) = 4.5% / 0.60 = 7.5%. A taxable bond would need to pay 7.5% to leave her with the same amount. On a $100,000 holding, 4.5% gives $4,500 of tax-free interest, while a 7.5% taxable bond gives 7,500 less 40% tax of $3,000, which also leaves $4,500. The calculation shows that a 4.5% tax-free yield is worth the same as a 7.5% taxable yield for this investor.Case study
Seen in the real world.
Bayside Family Office is an illustrative, fictional advisory firm managing money for a client who lived in a high-tax state and city. The client held $2,000,000 in taxable corporate bonds yielding 5.5%, producing $110,000 of interest a year.
The adviser worked out the after-tax result using a combined marginal rate of 40%. Tax took $44,000, leaving $66,000, or 3.3% of the amount invested. A local triple tax-free bond yielding 4.2% would produce $84,000 with no tax, which was higher.
The illustrative lesson is that the stated yield is not the whole story. The adviser moved $1,000,000 into local bonds, kept the rest in corporate bonds for diversification, and noted that the client's return depended on the tax rules staying as they were.
Watch out
Common mistakes.
- Assuming every municipal bond is triple tax-free, when the exemption usually depends on where the investor lives.
- Comparing a tax-free yield with a taxable yield directly, without converting to a tax-equivalent figure.
- Forgetting that capital gains on selling the bond may still be taxed.
Questions
People also ask.
Who benefits most from triple tax-free bonds?
People with high combined tax rates who live in the issuing state and city, since they gain the full exemption.
Is triple tax-free the same as tax-exempt?
Tax-exempt is the broader label, while triple tax-free means that federal, state and local taxes are all avoided.
Can the tax treatment change?
Yes, tax laws are set by legislatures and can change, so investors should check the current rules or ask a tax adviser before buying. The answer also differs for each person, because it depends on where they live and on their own tax bracket.
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