30.12 Investing in Tax-Exempts

Interest on state and local obligations is not subject to federal income tax. It is also exempt from the tax of the state in which the obligations are issued. In comparing the interest return of a tax-exempt with that of a taxable bond, you figure the taxable return that is equivalent to the tax-free yield of the tax-exempt. This amount depends on your tax bracket. For example, a municipal bond yielding 3% is the equivalent of a taxable yield of 4.167% subject to the tax rate of 28%.

You can compare the value of tax-exempt interest to taxable interest for your tax bracket by using this formula:

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The denominator of the above fraction is:

0.85 if your tax bracket is 15%
0.75 if your tax bracket is 25%
0.72 if your tax bracket is 28%
0.67 if your tax bracket is 33%
0.65 if your tax bracket is 35%
EXAMPLE
You are deciding between a tax-exempt bond and a taxable bond. You want to find which will give you more income after taxes. You have a choice between a tax-exempt bond paying 2.5% and a taxable bond paying 3.25%. Your tax bracket is 25%.
You find that the tax-exempt bond is a slightly better buy in your tax bracket as it is the equivalent of a taxable bond paying 3.33%.

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image Planning Reminder
Municipal Bond Funds
Instead of purchasing tax-exempts directly, you may consider investing in municipal bond funds. The funds invest in various municipal bonds and, thus, offer the safety of diversity. The value of fund shares will fluctuate with the bond markets. Also, an investment in the fund may be as small as $1,000 compared with the typical $5,000 municipal bond. Check on fees and other restrictions in municipal bond funds.
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Tax law restrictions.

Most state and municipal bonds that are issued before July 1, 1983, except for housing issues, are in the form of bearer bonds; the owners are not identified, and interest coupons are cashed as they come due. However, state and municipal bonds issued after June 30, 1983, with a maturity of more than one year, as well as obligations of the federal government and its agencies, are in registered form. Principal and interest are transferable only through an entry on the books of the issuer.

In buying state or local bonds, check the prospectus for the issue date and tax status of the bond. The tax law treats bonds issued after August 7, 1986, as follows:

1. “Public-purpose” bonds. These include bonds issued directly by state or local governments or their agencies to meet essential government functions, such as highway construction and school financing. These bonds are generally tax exempt.
2. “Qualified private activity” bonds. Interest on private activity bonds is taxable unless the bond is a qualified bond. Qualified bonds generally finance housing, student loans, or redevelopment, or they benefit tax-exempt organizations. Interest on qualified private activity bonds issued after August 7, 1986, although tax free for regular income tax purposes, is a tax preference item for purposes of computing alternative minimum tax (23.3) unless an exception applies. Because of the AMT, these private activity bonds may pay slightly higher interest than public-purpose bonds.
Several types of bonds have been excluded from private activity bond treatment so the interest is not treated as an AMT preference item, including qualified Section 501(c) (3) bonds, New York Liberty bonds, Gulf Opportunity Zone bonds, Midwestern disaster area bonds, and qualified housing bonds issued after July 30, 2008. In addition, any bonds issued in 2009 and 2010 that would otherwise be considered private activity bonds are not treated as private activity bonds, so the interest on the 2009/2010 bonds is not a tax preference item.
Your broker can help you identify bonds subject to and exempt from AMT preference item treatment.
3. “Taxable” municipals. These are bonds issued for nonqualifying private purposes. They are subject to federal income tax, but may be exempt from state and local taxes in the states in which they are issued.
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image Filing Instruction
Interest Subject to AMT
Interest on qualified private activity bonds issued after August 7, 1986, is tax free for regular tax purposes but may be a tax preference item for alternative minimum tax (AMT) purposes (23.2).
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