Income tax season is a good time to ask the question, "Should I be investing in tax-exempt municipal bond funds? And if I am, is it the right thing to do?"
Your decision-making process should address the following points:
- Consider your total portfolio stock/bond/cash allocation first. Your asset allocation will have the biggest impact on your investment return over time.
- Are your bond investments in a tax-deferred retirement account like a 401(k) or IRA or a taxable account like a single or joint account? Tax-exempt municipal bond funds should only be used in a taxable account.
- What is your "marginal income tax bracket" for federal and state income taxes? This is different than the "effective" income tax rate displayed by income tax software programs or simple calculations of your income tax divided by your income. The "marginal" income tax rate is the tax rate that would be applied to an additional dollar of income. It is outlined in the income tax tables available on paper income tax returns or the IRS or state income tax websites. For example, the federal marginal income tax rate increases from 15% to 25% at a taxable income (after deductions and exemptions) of $70,700 in 2012 for married couples filing jointly and $35,350 for single taxpayers.
- What is the "Taxable Equivalent Yield," or TEY, of the tax-exempt municipal bond fund? This represents the interest rate you would have to earn in a comparable taxable investment. If the TEY is higher, go for tax exempts. Before doing this calculation, be sure you are comparing funds of comparable maturity range and credit quality. A short-term, high-quality fund will have a lower interest rate than a longer term, low-quality fund. Make sure you are comparing apples to apples. Also, be sure you are using a fund’s "SEC Yield" when comparing funds, so that the yield is calculated in an identical manner. Believe it or not, there is more than one way to calculate a "yield." If only life could be simpler!
- The formula for the Taxable Equivalent Yield is the tax-exempt yield divided by (1 minus marginal income tax rate). For example, John and Susie Smith have a taxable income of $50,000 and therefore are in the 15% federal marginal income tax bracket. They are comparing two intermediate-term, high-quality bond funds. One is invested in tax-exempt bonds with an SEC yield of 1.87% and the other is invested in taxable bonds with an SEC yield of 2.83%. The TEY of the tax-exempt fund is 1.87% divided by (1-0.15) which equals 2.2%. Since this is less than the taxable yield of 2.83%, John and Susie are better off in the taxable bond fund.
- Before investing or making any changes, consider whether you think your income will go up or down in the current year or future years. Also, if you are switching from an existing fund, beware if your current fund has a capital gain. Many funds have capital gains since interest rates have been declining for several years.
In closing, your decision about investing in tax-exempt municipal bonds should be reviewed annually. The current low interest rate environment and low tax bracket environment makes taxable bonds more appealing, but interest rates and income tax rates are always subject to change. This is a simple process to follow to be sure your money is invested most productively.
About Bruce J. Berno, CFP®
Bruce J. Berno, CFP® is the founder of Berno Financial Management, Inc. a fee-only comprehensive personal financial planning and investment advisory firm headquartered in Cincinnati, Ohio. Since 1993, Berno Financial Management has been helping individuals and families achieve financial peace of mind. For more information about Berno Financial Management, visit http://www.bernofinmgt.com/.