Tax Exempt Bond vs. Tax Bond

by Jack Ori

Municipal bond funds and mutual bond funds allow investors to loan money to companies or municipalities. Most municipal bond funds are tax exempt, while mutual bond funds are not. The best investment depends on the tax bracket an investor falls into and whether municipal bonds are subject to the alternative minimum tax.

Tax Rate

The tax rate on taxable bonds may make tax-exempt bonds a better investment. Even if taxable bonds have a higher yield, the taxes on that yield may reduce it so that you get a higher return on your investment. For example, Personal Fidelity suggests that if a tax-exempt bond yields $400, a comparable taxable bond might only yield $368.50 or $396, depending on your tax rate.

Taxable Equivalent Yield

When comparing tax exempt bonds to taxable bonds, you can determine the relative yields by using a formula. Subtract your federal tax rate from 1.00 and divide the yield from your tax-exempt bond by the result. This tells you how much your taxable bond has to yield to get the same return as you would get on your tax-exempt bond. For example, if the tax-exempt bond yields $400 and your tax rate is 28 percent, divide 400 by .72 to determine that your taxable bond must yield $555.

Alternative Minimum Tax

Although most municipal bonds are tax-exempt, some municipal bonds are subject to alternative minimum tax. If a municipal bond is used to cover the cost of certain projects, such as building hospitals, you must pay this tax on it. The alternative minimum tax was designed to ensure that corporations and other high-income earners pay their fair share of tax, so it is likely to be higher than the tax on a taxable bond.

Considerations

If you are in a low income tax bracket, there won't be much of a difference in yield between taxable bonds and municipal bonds. The higher your tax bracket is, the more money you save by investing in tax-exempt municipal bonds instead of taxable bonds, unless the municipal bonds are subject to alternative minimum tax.