Tax-Exempt vs. Taxable Bonds
Discounts, Premiums, Yields and Interest Rates are all Important
Sep 30, 2009
Bonds provide a way to invest with less risk than stocks. The returns can be lower, but return of principle and a fixed interest rate are more likely, though not guaranteed.
Many bonds issued by states and municipalities are tax-exempt, which means that the interest on them is not subject to federal taxes, and in some cases, state taxes.
These bonds carry a lower interest rate, but the savings on taxes may justify purchasing a tax-exempt bond compared to one where interest is taxed.
Interest Rate and Yield
Each bond has an interest rate, the amount of interest that is paid to the bondholder. The interest rate is based on the face amount of the bond. For instance, a bond with a face value of $1,000, and an interest rate of 5% per year would pay $50 per year.
The actual price of a bond may vary from face value based on prevailing rates in the market. If the market interest rate is 6%, the price of the bond will be adjusted to reflect a yield of 6%, despite the interest rate of the bond.
This is accomplished by selling the bond at a discount. For instance a one year bond with a 5% interest rate would be priced at $990 to arrive at a yield of 6%. If the market rate is lower than the interest rate of the bond, the bond is sold at a premium.
Since market rates change over time prices on bonds vary, but if a bond is held to maturity, (and there is no default), the full face value plus interest will be returned to the bondholder.
Tax-Exempt Bond Interest Rates
Compared to the taxable bond above, a comparable tax-exempt bond would carry a lower interest rate, and would be priced by the market at a comparable lower yield. When the benefits of tax savings are included, tax-exempt bonds make more sense. For example, compared to the 5% bond above, a similar term tax-exempt bond might carry an interest rate of 4%.
Marginal Tax Brackets
In order to calculate whether tax-exempt bonds are a better deal, it is necessary to know the marginal tax rate. This rate is the highest rate that applies to the taxpayer, not their overall percent of taxes paid to income. Because the United States uses a progressive tax system, the tax rate increases with income.
The marginal tax rate, also referred to as the taxpayer's tax bracket, it is the tax rate that additional taxable income would be taxed at, which may vary by taxpayer.
The Benefits of Tax-Exempt Bonds
If that rate is 28%, then tax-exempt bonds will result in a net higher income after taxes.
To calculate:
- Taxable- $50 interest less $14 ($50*28%) equals $36
- Tax-exempt- $40 less $0 (not taxed) equals $40
Different tax rates for the individual and different interest rates for the bond may cause a different result, so it is important to use real numbers for each situation. If the interest rate in the example above was 3%, the taxable bond would be the better choice.
Bonds are a simpler and less risky alternative to stock investments, but taxpayers need to analyze all aspects of the investment to maximize income and minimize taxes.
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