October 11, 2010

Municipal Bonds: A Little Home Cooking

By Steven D. Brett, Managing Director, Partner, Marcum Wealth

Municipal Bonds: A Little Home Cooking

Once the almost exclusive domain of institutional investors, the municipal bond market has become a magnet for individual investors. Since these bonds are issued by state and local governments, the principles of federalism (remember high school civics?) demand that the interest from municipal bonds be exempt from federal taxation. Although they are generally free from federal taxes, these bonds may be subject to state and local taxation. The interest on private activity bonds may not be tax-free under the alternative minimum tax system. The popularity of municipal bonds has soared among individuals as they seek federal tax-free interest to combat the inherent penalties of high income: deduction and exemption limitations and higher marginal tax rates.

A municipal bond is essentially a promissory note. When an investor buys a municipal bond, he/she is lending money to the issuing state or local government. In return for the loan, the issuer pays interest at a specified rate and, at the end of the period, pays back the principal. Funds raised through the sale of municipal bonds are generally used to finance projects that benefit the public. The two most common types of municipal bonds are general obligation bonds and revenue bonds. General obligation bonds are backed by the “full faith and credit” and the taxing power of the issuer. Revenue bonds are secured by the income from the specific project they were issued to finance.

Comparing the yield on a municipal bond to the return on a similarly rated, fully taxable investment is basically a function of the investor’s tax bracket. Generally, the higher the tax bracket, the more the potential benefit from investing in municipal bonds. To illustrate this point, if an individual is in the 25% federal tax bracket, a municipal bond paying interest at 6% will generate the same amount of income -after tax- as a fully taxable investment earning interest at 8%. For an individual in the 35% bracket, that same municipal bond paying interest at 6% will be equivalent to an almost 9.2% taxable return. This taxable equivalent yield will be even greater for investors who purchase home state bonds as these are also exempt from their respective state income taxes. Remember, investing involves risk and you may incur a profit or a loss. The example provided is hypothetical and does not suggest or guarantee particular rates of return for any investment.

Another important factor in evaluating municipal bonds is how long the investment will last. Different bonds have different maturity dates and choosing the maturity date that is right for an investor depends upon his/her own investment objectives. Retired individuals who are collecting social security should be aware that municipal bond income is included in the determination of taxable social security benefits even though it is not part of their federal taxable income.

Municipal bonds offer an attractive investment alternative for many individuals. They can be purchased directly or through tax-free bond funds or unit investment trusts (UIT). Remember to compare returns on municipals with other investments using a taxable equivalent yield based upon the investor’s marginal tax rate. Of course, this brief article is no substitute for a careful consideration of each investor’s particular financial situation. Before implementing any significant tax or financial strategy, contact an investment advisor.

This material was prepared by Raymond James for use by Steven Brett, President Marcum Financial Services and Branch Manager at Raymond James Financial Services, Inc. Member FINRA/SIPC.