Investments With Tax Exempt Interest Income
Municipal bonds are securities issued by cities, counties, states and other governmental entities to finance projects that are considered beneficial to the public good. Likely projects are: housing, schools, highways, hospitals, sewer systems and other infrastructure.
Municipal Bonds: An Overview
Municipal bonds are appealing to some investors because their interest income is typically exempt from federal taxation and, in most cases, from state and local taxes, if the investor resides in the state of issuance.1 This tax advantage may provide investors in high tax brackets with a greater after-tax return than an investment in taxable securities with higher nominal yields.2
Compare Your Potential Returns
You can compare the yield a taxable investment would have to earn to the tax exempt return offered by a municipal bond. This formula is known as the taxable equivalent yield (TEY), and Morgan Stanley provides an online calculator to help you evaluate taxable and tax exempt bonds.3
To Use the TEY Calculator:
- Enter Your Tax Free Yield
- Select your tax bracket and the state in which you live
- Press Calculate
Municipal Bond Types
- General obligation (GO) bonds and revenue bonds are the two most common categories of municipal securities. There are two types of GO bonds: unlimited tax and limited tax. The principal and interest payments of an unlimited tax GO bond are backed by the full faith, credit and taxing power of the issuer. Should the borrower default, ad valorem (property) taxes can be levied without limit or amount to satisfy debt service. Limited tax GO bond interest payments are restricted to a specific revenue stream or amount within a tax, and there may be no pledge to raise taxes if there is a revenue shortfall.
- Revenue bonds, in contrast to GOs, make interest and principal payments solely from the revenue generated by the funded project; for example, bridges, toll roads, electric power plants and wastewater treatment facilities.
- Prerefunded municipal bonds are created when municipalities issue new securities to refinance outstanding debt that was issued at a higher rate. Once the refinancing is completed, the issuer uses the proceeds to purchase US Treasury securities, which are placed in an escrow account. The proceeds from the escrow account are then used to pay interest and principal on the original debt until the issue is called or matures.
- Taxable municipal bonds represent a small segment of the municipal bond market that is not tax exempt. They are issued to finance projects that don't provide a significant benefit to the general public. Bonds issued to finance local sports facilities or underfunded public pensions are examples of federally taxable municipal securities. Depending on credit quality, taxable municipal bonds may offer returns comparable to taxable securities, such as corporate bonds, and may be suitable for retirement accounts.
Consider the Risks
Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.
1 Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax exemption applies if securities are issued within one's state of residence and, if applicable, local tax exemption applies if securities are issued within one's city of residence. The tax-exempt status of municipal securities may be changed by legislative process, which could affect their value and marketability.
2 The tax advantage of municipal bonds is eliminated if they are held in tax-sheltered accounts, such as a regular IRA, SEP or Qualified Plan, since (a) funds withdrawn from a tax sheltered account are taxed at distribution and if withdrawn prior to age 59 ½ may be subject to a 10% federal tax penalty, without regard to whether the interest/principal originally came from a tax-exempt source, and (b) all qualified distributions out of Roth IRAs are tax-free, again regardless of origin. Speak to your Tax or Legal Advisor for further information.
3 The taxable equivalent yield (TEY) measures what an investor would have to earn (yield) on a taxable (or fully taxable) investment in order to match the yield provided by a tax-exempt municipal bond. The TEY is only one factor that should be considered when purchasing a security, and is meant to be used only as a general guideline when determining taxable equivalent yields for agency and treasury securities. The state and/or local tax rates shown represent the maximum state and/or local income tax in each state and/or locality. Some states and localities have lower tax rates within each federal tax bracket in relation to income level and type of filing. If state and/or local tax rates are lower than posted, taxable equivalent yields may be lower than shown. The effective combined rate assumes the taxpayer itemizes his / her deductions. The factors do not adjust for: the imposition of Medicare surtax nor the phase-out of itemized deductions, personal exemptions or the reduction of any credits that may occur for certain high income taxpayers; the yield to maturity factoring in market discount or market premium, or the effect, if any, of the federal Alternative Minimum Tax (AMT).