Given how much Americans hate taxes, it's shocking to discover that out of nearly 150 million tax returns filed, fewer than 4% took advantage of a simple method of earning tax-free income. Yet the roughly 5.8 million who did reaped some handsome rewards, adding a five-digit figure on average to their total income without having to pay tax on it.
This simple way of getting income tax-free involves investing in municipal bonds. Not everyone is familiar with municipal bonds, but they have tax advantages and can also be good additions to a broader investment portfolio.
What are municipal bonds?
State and local government issue municipal bonds when they need to raise capital in order to pay for various types of public projects. The federal government allows most investors in these debt securities to exclude the interest payments they receive from their taxable income. That encourages state and local officials to take on projects that are in the public interest.
Municipal bonds give an advantage to the issuing government entities as well. Because interest is tax free, the interest rate that states and local governments have to pay is typically less than it would be if the interest were fully taxable. That saves on borrowing costs and makes necessary debt less difficult to handle.
Municipal bonds aren't just good on federal tax returns. If you pay a state income tax, then investments in municipal bonds that are issued by a government within that state will typically be state-tax-free as well. With cities like Philadelphia and New York imposing city-level income taxes, municipal bonds from those municipalities enjoy triple-tax-free benefits, escaping federal, state, and city income taxes.
Why don't more people invest in municipal bonds?
Despite their tax advantages, municipal bonds aren't all that popular among investors. The number of taxpayers claiming tax-exempt municipal bond income on their returns was less than 5.8 million in the most recent year for which the IRS has data, leaving roughly 143 million taxpayers choosing not to take advantage of the provision. Yet those who did take advantage of the provisions used it extensively, earning about $62.5 billion in tax-free interest that worked out to an average of $10,772 per taxpayer.
One reason why more people might not use municipal bonds is that the value of the tax break associated with them varies by your tax bracket. For instance, high-income taxpayers get a huge benefit from municipal bonds, because they'd otherwise have to pay 39.6% in tax on the interest. That makes a municipal bond paying 3% in tax-free income equivalent to a taxable bond with a much higher yield of almost 5%.
By contrast, for those who don't earn enough income to pay any tax at all, a municipal bond yielding 3% isn't worth any more than a taxable bond yielding 3%. In the 10% tax bracket, the tax-equivalent yield of the bond would be 3.3%, and effective tax-equivalent yields for the 15% to 35% tax brackets range from 3.5% to 4.6%.
What's most surprising in light of the tax impacts of municipal bonds is that the current market rates for taxable and tax-free bonds shows only small differences in yield. For instance, high-rated 10-year muni bonds recently yielded 2.35%, compared to a roughly 2.5% rate on the 10-year Treasury bond. Longer-term bonds actually have the municipal market offering higher rates, with 30-year munis averaging a 3.1% yield even as Treasuries are a bit closer to 3%.
The current market shows longer-term concerns about the ability of state and local government to keep paying off their debt. Delinquency rates in the past have been quite low, despite some high-profile municipal insolvency situations that have had implications for municipal bond investors. Yet with the nation's infrastructure in decay, plans to boost spending will require more debt, and that could boost supply in a manner that some fear could be unsustainable.
Despite those concerns, though, municipal bonds generally can be especially lucrative for taxpayers seeking to cut their tax bills. The higher your bracket, the more you'll benefit from selectively choosing high-quality municipal bonds and reaping the tax-free income that they pay.