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Taxable vs. Tax Exempt Bonds: What is Your Best Option?

December 05, 2013

Bonds carry their own level of calculated risk and potential returns. Learn which type is your best option.

Bonds have historically been considered a conservative and safe investment tool for the risk-averse individual, and many investors who manage a portfolio of diversified assets incorporate bonds into their investment profile. Although bonds, overall, do serve as a less volatile type of investment, there are different types of bonds that each carry their own level of calculated risk and potential returns.

Before delving into which bonds may extend the highest rates of return and low levels of risk, it’s important to first understand that bonds are divided into two classes: taxable and tax-exempt. Knowing the differences between the two can help investors make a more informed decision, which may be more financially advantageous.

Tax-exempt municipal bonds

Tax-exempt bonds, as the name suggests, are generally not subject to federal income taxes, but may carry lower rates of return than taxable bonds. Additionally, bonds issued by a state government are also typically free from state taxes, and those issued by a municipality or town may also be exempt from local taxes. In addition to their tax-exempt status, these bonds have historically been popular among risk-averse individuals because they are generally backed by more secure issuers. To better demonstrate this, there are two types of tax-exempt bonds, the features of which are outlined below:

  • General obligation bonds. These bonds are funded through tax collections of the municipality, which generally includes property taxes. While historically popular, housing market volatility and recent high-profile bankruptcy cases of municipalities in California have caused some investors to take a more cautious stand toward these bonds.
  • Revenue bonds. These types of bonds are funded by revenue generated through specific state and local projects, which may range from infrastructure, highway and public works projects.

Taxable Bonds

Unlike their tax-exempt counterparts, taxable bonds are subject to federal and state tax and are typically backed by the issuing company’s future income. Examples of taxable bonds include:

  • U.S government bonds
  • Mortgage-backed securities
  • Corporate bonds
  • Global bond funds
  • Diversified bond funds

Which is the better option?

Choosing between taxable and tax-exempt bonds is not always a black and white decision, and requires investors to instead consider their tax bracket and the results of a mathematical formula that outlines the taxable equivalent yield of a tax-exempt bond. As a general rule based on the formula, most investors in higher tax brackets may gain larger returns by investing in tax-exempt municipal bonds, rather than taxable bonds. Review the formula and several examples listed below to compare the various taxable vs. tax-exempt scenarios:

Taxable Equivalent Yield = Tax-exempt yield / 1 – [tax bracket]

As the first example, let’s say the tax-exempt yield of a municipal bond is 5 percent and the investor is in the low 15 percent tax bracket. The formula would read as follows:

5/1 - 0.15 = 5.88 percent

The results of the formula denote that a comparable taxable bond would have to yield 5.88 percent to equal the return of a 5 percent tax-exempt bond. However, the comparable taxable bond yield would be significantly higher for those in the higher 35 percent tax bracket, as evidenced below:

5/1 - 0.35 - 7.69 percent

Given that investors in high income brackets who purchase taxable bonds would have to attain significantly higher yields to obtain the same returns as those offered by a tax-exempt bond, most high-income earners typically gravitate toward municipal bonds. As is the case with most investments, this is not always the case and special circumstances may apply. For this reason, it’s always a wise move to work with a tax or accounting professional that can review the calculations and take a more comprehensive look at your overall financial picture and investment goals.

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