No one likes to pay taxes, and Americans go to great lengths to cut their tax bill. It's therefore fairly surprising to find that out of more than 147 million returns, only 6 million -- about 4% -- took advantage of an easy way to earn tax-free income. Those who did, however, brought in an average of more than $11,000 that avoided taxes entirely. Below, we'll take a closer look at how you can earn tax-exempt income by investing in municipal bonds and what the true benefits are.
Understanding municipal bonds
Municipal bonds are debt securities that state and local governments issue in order to finance public projects. In order to encourage these projects, the federal government allows the holders of most types of municipal bonds to exclude the interest payments that they receive from the municipal bond issuer. The net impact is typically to reduce the interest rate that states and municipalities have to pay, because investors are willing to accept a lower rate than they would if they knew they would lose some of their interest income to taxation.
In addition to their federal tax benefits, municipal bonds can also help taxpayers in other ways. If you invest in a municipal bond that's issued by a government within your state, then the income will generally be free from state income taxation as well. Those who live in cities such as New York City and Philadelphia can invest in local bonds that are exempt from local city income taxes, allowing investors to benefit from so-called triple-tax-free treatment.
As valuable as tax-free income is, you'd think that more people would use municipal bonds as part of their investing strategies. Yet tax-exempt municipal bond income showed up on just under 5.99 million tax returns in the most recent year for which the IRS has data, leaving the vast majority of the 147.4 million taxpayers filing returns that year out of the loop. However, when you consider that in total, taxpayers earned about $68.1 billion in tax-free income using muni bonds, the average works out to $11,374 per taxpayer.
Who gets the most from municipal bonds?
The key element about investing in municipal bonds is that the value of tax-exempt income depends on what tax bracket you're in. As an extreme example, if you earn so little total income that you don't have to pay taxes at all, then investing in a municipal bond won't give you any advantage over a taxable bond. Even if you're in the 10% bracket, the low tax rate makes a municipal bond's advantages relatively small. For such a taxpayer, a municipal bond paying 2.7% would be roughly equivalent to a taxable bond with a 3% interest rate.
By contrast, high-income taxpayers reap big benefits from municipal bonds. The same 2.7% municipal bond for someone in the 39.6% tax bracket would be equivalent to a taxable bond paying a much higher rate of almost 4.5%. Those in brackets between those two levels will find their equivalent pretax yields to be on the middle of that range.
Yet the interesting thing about the municipal bond market lately is that the differences between taxable and tax-free rates haven't been all that large. Recently, the yield on typical 10-year municipal bonds was 1.82%, compared to 1.87% on 10-year Treasury bonds. In fact, with 30-year bonds, the relationship was actually the reverse of the normal situation. Treasuries yielded 2.69%, while a 30-year muni bond offered 2.83%.
What's behind this unusual situation? Investors are concerned about the potential for default. The Treasury can always issue money to cover debt, so it has no default risk. State and local governments don't have that power, and increasingly, pressure on budgets has led to tough decisions for many hard-hit communities. The risk of holders of municipal bonds losing their principal isn't all that great, but it's enough to justify yields that are higher than Treasuries even though munis are tax-free and Treasuries aren't.
Municipal bonds aren't for everyone, and they won't necessarily save all taxpayers a ton of money. But especially for those in higher tax brackets, it can make a lot of sense to look at municipal bonds and their tax-free income.