Keep More of Your Money: Tax Free Municipal Bonds

There are very few ways in which you can earn something and not have to pay any taxes. And for many investors, earning interest on savings is important, but understanding how much you get to keep is important. This is where tax free municipal bonds can play an important role in a comprehensive wealth management strategy.

For Connecticut residents, municipal bonds can offer a unique opportunity to generate income that may be exempt from both federal and Connecticut state income taxes, potentially increasing after tax returns without increasing investment risk.

What are Municipal Bonds?

Municipal bonds are issued by state and local governments to fund certain projects such as schools, roads, highways, infrastructure improvements, etc.   In return for lending money to these entities, investors receive an interest payment and the return of principal at maturity.   One of the major benefits of municipal bonds is that the interest is generally exempt from federal income taxes.   Additionally, Connecticut residents who purchase bonds issued by Connecticut municipalities may also receive exemption on state tax.

 Why do taxes on interest matter more than the rate or yield?

Investors make the mistake of comparing yields on fixed income/bonds without considering the taxes.  A taxable bond may offer a higher stated yield, but after taxes, the difference in yield may shrink or even be wiped out.

Let’s consider an example.

Example: Connecticut investor in a higher tax bracket evaluating two different investment options:

• Corporate Bond Yield: 25%
• Connecticut Municipal Bond Yield: 75%

If the investor is subject to 35% Federal Income Tax rate and 6% CT State Tax, the combined tax burden is 41%. The after-tax yield would be 3.10% (5.25% x 1 – .41%). Compared to the CT tax free bond at 3.75% generates more income after taxes.

Tax Equivalent Yield

Tax equivalent yield is the return an investor needs to earn on a taxable bond to match the after-tax income generated by a tax-free bond.  Using the example above, you would take the tax-free yield of 3.75% divided by 1 – tax rate or .41 = 6.36%. Therefore, this investor would need to earn 6.36% on a taxable bond to match the after-tax income generated on a CT municipal bond yielding 3.75%.  This can be a powerful advantage for high income earners, business owners, and retirees.

Are Connecticut Municipal Bonds right for you?

Municipal bonds may be especially attractive for:

• High Income earners
• Investors in high federal tax brackets
• CT residents seeking tax efficient income
• Individuals looking to reduce overall portfolio volatility.

However, municipal bonds are not one size fits all solution.  Investors in lower tax brackets may find taxable bonds or CD’s more attractive on an after-tax basis depending upon interest rate conditions.

Bottom Line

For some investors, municipal bonds can provide more than just steady income – they can provide an opportunity to improve after tax returns by avoiding both federal and state income taxes on qualifying bonds.

Before investing, it’s important to evaluate municipal bonds within the context of your overall financial plan, income needs, risk tolerance, and tax situation.   A personalized financial review and help determine whether municipal bonds belong in your portfolio and how they can complement your other investments.