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Tax-exempt bonds vs. taxable bonds

Chris Farrell Aug 4, 2009

Question: If a corporate bond paid 9% interest, and you are in the 28% income tax bracket, what rate would you have to earn on a general obligation municipal bond of equivalent risk and maturity in order to be equally well off? Given that municipal bonds are often not easily marketable, would you want to earn a higher or lower rate than the rate you just calculated? Sandra, Upper Marlboro, MD

Answer: Ah, this is the kind of question that number-crunchers love and everyone else hates. So, I’ll keep it simple. The good news is that I don’t need to write out the basic formula and you don’t need to do the math. There are calculators on the web that will do it for you.

Yes, you do want to make an apples-to-apples comparison. A key step is to put investment yields on a level playing field. When you’re comparing a taxable bond to a municipal bond you’ll use the tax-equivalent yield formula to do just that.

So, with your 9% corporate bond you would need a tax exempt bond that yielded at least 6.48% to match it. I plugged the numbers into this calculator. It only takes into account federal taxes. A more detailed calculator that lets you plug in state and local taxes is at CNNmoney.com.

You do want to make sure that you are comparing bonds with similar maturities and credit quality. I’m not a big fan of owning individual munis and corporates. I think most individuals will do better with low-fee bond mutual funds with these securities. With some 48 states in the red a bond fund is allows for prudent diversification.

I would stick to high-quality blue-chip corporate and muni bonds. I would steer clear of low-rated junk, especially with a long maturity. The lush yields you can earn on high yield corporates and high yield munis isn’t enough to compensate for the risk of the investment going sour.

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