The incentive for investors to buy bonds is the interest income bonds provide. Naturally, you want the highest annual return you can find, as long as your investment risk is acceptable. However, the best rate of return isn’t always obvious. That’s because some bonds have tax advantages. Since your after-tax earnings are what really count, a tax-advantaged bond might be a better deal than another bond with a higher stated rate of return.
Effective Annual Return
Bonds are debt securities that pay a fixed amount of interest each year. For example, a bond might pay 7.5 percent of the bond's face value (the amount the bond issuer must give a bondholder to pay off the debt when the bond matures). As bonds trade on the market, their prices vary. This causes the bond’s effective rate of return, called the yield, to vary as well. To calculate the yield, divide the price paid for the bond into the annual interest amount. For example, a $1,000 face value bond paying $75 per year (7.5 percent) will have an effective rate of return of 6 percent if the bond price rises to $1,250.
Bonds and Taxes
The interest you earn from bond investments is considered earned income by the Internal Revenue Service (IRS) and is normally taxed at your federal marginal tax rate. The marginal rate is the maximum tax percentage rate you pay on any of your income. However, interest earned on state and local government bonds (collectively called municipal bonds) is often exempt from federal income taxes. As a result, your after-tax yield on a municipal bond might be better for a municipal bond compared to a corporate bond, even if the corporate bond has a higher stated yield.
Bond Equivalent Yield
To compare tax-exempt municipal bonds and taxable bonds, you can calculate the bond equivalent yield, also called the tax equivalent yield. This is the yield a taxable bond must have to provide the same after-tax income as a municipal bond. To compute bond equivalent yield, first subtract your marginal tax rate from 1. For example, if your marginal tax rate is 28 percent, subtract 0.28 from 1, leaving 0.72. Divide this figure into the municipal bond yield. Thus, if the municipal bond yield is 4.5 percent, you have 0.045/0.72, which gives you about 6.4 percent. That is the effective annual return you need from a taxable bond to give you the same after-tax income you will get from the municipal bond.
Other Tax Issues
If you buy bonds in an IRA, 401(k) or similar retirement account, the interest earned is not taxed while it remains in the account. When the money is withdrawn, all of it will either be taxed as ordinary income or, for Roth IRAs, not taxed at all. Either way, there’s no tax advantage to having tax-exempt bonds in one of these tax-deferred investment accounts. Another thing to keep in mind is that states often exempt municipal bond income from state income tax when the bond is issued within that state, at least for state residents. When you evaluate the tax equivalent yield of such a bond, add the state tax percentage rate to your federal marginal tax rate before calculating tax equivalent yield.
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