A major investment choice comes when you must decide between bonds paying taxable interest and those that are exempt from income tax. Bonds have different features, liquidity and credit quality. Your personal tax situation will make one type or the other a better choice for you.
The types of bonds that pay taxable interest include government and corporate varieties. U.S. Treasury bonds can be easily bought and sold and are considered the safest investment securities. Treasury securities set the base interest rates against which other bond types are judged. Bonds issued by corporations range in quality from investment grade bonds to high-yield, noninvestment-grade bonds, often referred to as "junk" bonds. Bonds with lower credit ratings pay higher yields but have higher risk of default.
Nontaxable bonds, or municipal bonds, are issued by state and local governments. Their interest is exempt from federal taxes, and if you buy bonds issued in your state, it is also exempt from state income taxes. Municipal bonds are either general-obligation bonds, which are backed by the full taxing authority of the issuer, or revenue bonds, which are paid off from the earnings of a specific project. Municipal bonds tend to be less liquid than government bonds and corporate bonds from large companies. Investors should view tax-free bonds as buy-and-hold investments.
Taxable Equivalent Yield
A concept that will help you determine whether to invest in taxable or tax-free bonds is the calculation of the taxable equivalent yield. This is the yield you would need to earn from a taxable bond to generate the same after-tax yield as a tax-free bond. Calculate the taxable equivalent yield by dividing the tax-free yield by 1 minus your marginal income tax bracket. For example, if you are in the federal 28 percent tax bracket, a 3 percent tax-free yield is divided by 0.72 to give a taxable equivalent yield of 4.17 percent.
To decide between a taxable and tax-free bonds, you should compare bonds with similar credit ratings and time to maturity. A tax-free bond with a high credit rating and a 4.7 percent taxable equivalent yield is a safer investment than a taxable bond paying 5 percent with a low credit rating. Do not buy tax-exempt bonds just to get the tax-free income if you are in a lower tax bracket or can invest in taxable bonds with yields above the taxable equivalent rate.