Once taxes get involved, a bond’s stated interest rate, or coupon rate, can be deceiving when it comes to how much interest income will be received. Sometimes it ends up being wiser to invest in tax-free options. When looking for bond funds to purchase, it is vital to consider the possible benefits of tax-free interest growth.
First, it is important to know what investments are typically tax-exempt and which are not. Usually, the coupon, or interest payment, on corporate bonds is taxable. Technically, the term “corporate bonds” refers only to those issued by corporations. Sometimes the term is less formally used to refer to all bonds not issued by governments. The point is, payments from these are usually taxed.
On the other hand, municipal bonds are issued by a local or city governments and their agencies. Payment from these is usually not subject to federal income tax. A few examples of such issuing entities are cities, counties, school districts, and public utility districts. These coupons are often exempt from state and local taxes as well.
The most important advantage of purchasing a tax-free bond is the possibility of receiving a higher interest payment than with a taxed one. This often occurs even though the taxed one has a higher yield. Many times, even if a taxed and a tax-free investment have the same coupon rate, depending on the tax bracket in which the bondholder falls, the tax-free bondholder might receive more payment.
To illustrate, assume three bondholders are going to invest $10,000 each. The first investor buys a municipal bond fund that yields 4% interest payment. The bond is tax-free, so $400 of interest income is received. The second investor buys a corporate bond that is taxable, and yields 5.5%. If the tax rate is 28%, the interest income after taxes is only $396. Assume the third investor buys a bond fund also yielding 5.5%, but taxed at 33%. The income after taxes would be a mere $368.50.
As illustrated, although the corporate bonds had higher yields, the bondholder with the tax-free municipal bond received more income interest. The general rule to follow is that if an investor falls in an income tax bracket greater than 28%, it is likely that a tax-free bond will be advantageous. Comparisons are essential in determining whether tax-exempt bonds are best for a particular investor.
Also, the default rate is usually lower on municipal bonds, making them less risky, although this varies depending on many factors. Municipal bonds can also be traded freely as soon as they are purchased, unlike corporate bonds. When investing it is important to always keep in mind other strategies as well, such as having a diversified portfolio. Keeping a diversified portfolio is vital in minimizing risk and ensuring a steady investment income.
Smart investors consider a lot more than just the coupon rate on a potential bond. Depending on one’s tax bracket, a lower yield, but tax-free bond might earn more money. Knowing these tax implications regularly puts investors ahead of the game and earning more profit.
