How to Calculate an Effective Rate for a Municipal Bond

by Mark Kennan

The federal government does not tax the interest taxpayers earn on municipal bonds. Therefore, when comparing municipal bonds to other taxable investments, such as stocks or corporate bonds, you must account for the value of this tax break when figuring which investment will generate the largest return for you. The tax breaks for municipal bonds make them more attractive to people who fall in higher income tax brackets, because the higher your income tax bracket, the larger the tax break.

1. Divide your federal income tax rate by 100 to convert to a decimal. For example, if you fall in the 25 percent tax bracket, divide 25 by 100 to get 0.25.

2. Subtract the result from 1 to find the portion of each dollar of interest you keep after taxes. In this example, subtract 0.25 from 1 to get 0.75.

3. Divide the interest rate of the municipal bond by the result to find the effective interest rate on the bond. In this example, if the municipal bond pays 5.2 percent interest, divide 5.2 by 0.75 to find the effective interest rate after taxes equals 6.93 percent.

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