Municipal bonds, informally called "munis," are debt securities issued by state and local governments to borrow money. The money raised by selling municipal bonds may be used to build roads, hospitals, schools and similar projects. Most municipal bonds offer tax breaks to attract investors. These tax breaks affect the effective rate of return the interest on munis provides.
When a municipal bond is issued by a state or local government for a purpose that serves the general public good according to federal guidelines, the interest the bond pays is exempted from federal income taxes. States frequently make the interest on municipal bonds exempt from state taxes, as well, if you are a state resident. The interest on municipal bonds issued in United States territories and Puerto Rico is exempt from state and local taxes no matter where the bond holder lives.
Municipal bonds pay a fixed amount of interest each year. Called the coupon rate, this interest is a percentage of the par value of the bond. Par value is the amount the bond issuer pays when the bond matures, or comes due, in order to repay the borrowed money. Your actual rate of return, or yield, will be different than the coupon rate if you buy the bond for a price other than the par value. Suppose you buy a muni with a par value of $5,000 that pays $150 yearly or a 3 percent coupon rate, however, you pay only $4,000. Your yield is equal to the coupon amount divided by the price you paid, which works out to a yield of 3.75 percent. This yield is your actual rate of return.
Taxable bonds, such as those issued by corporations, usually pay higher yields than tax-free munis. The money you keep after taxes is what counts, so you need a way to compare the yields of taxable and tax-free bonds. That’s what a tax-equivalent yield does. To calculate tax-equivalent yield, subtract your marginal tax rate from 1. Marginal tax rate is the highest rate of income taxes you pay on any of your income. Divide the municipal bond yield by the result. If the resulting tax-equivalent yield is higher than a taxable bond yield, you end up with more money with the tax-free muni. Suppose your marginal tax rate is 25 percent and a municipal bond has a yield 4.8 percent. Subtract 0.25 from 1, leaving 0.75. Divide 4.8 percent by 0.75 and you get 6.4 percent. A taxable bond must have a pretax yield of over 6.4 percent to provide an after-tax rate of return better than what the muni pays.
If you are subject to the alternative minimum tax, municipal bonds may lose their tax-free advantage if they are issued for joint public-private activity purposes. Another thing to remember is that the tax-exempt status only applies to interest paid by a muni. If you purchase a municipal bond and later sell it for more than you paid, you have a taxable capital gain. If you sell for less than what you paid, you have a capital loss that may be tax-deductible.