Often, when discussing bond investments, people bring the idea of using municipal bonds. If the investments in question are in a non-retirement fund, this can make sense. But, how do we evaluate it?
Let’s take a look
First, some quick background. Municipal bonds are loans from the public to municipalities such as cities, counties, or states. They fund things such as roads, water projects, airports, and other non-federally funded infrastructure projects.
Interest on municipal bonds to not get added to your income for federal taxes as do corporate or US Treasure bond interest earnings. So, municipal bonds can pay lower interest and still keep investor’s attention.
But, muni’s are not for everyone.
To find out if a municipal bond is the right choice for you, there is a quick calculation. In this case, we will compare a taxable bond fund (Vanguard Total Bond Market II Index with an SEC 30-day yield of 3.32% at the time of this writing) and a municipal bond fund (Fidelity Municipal Income, 2.91% 30-day yield).
The formula to compare is this: Muni Bond Yield / 1-your marginal tax bracket
In this example, say your highest tax bracket 25%. The formula is 2.91%/.75 = 3.88%. 3.88% is higher than the comparable taxable bond fund (3.32% above), so the municipal bond fund is a better choice for you.
Now, what about if your tax bracket is lower? Say, 10%. 2.91/.90 = 3.23%. This is a little less than the yield of the taxable bond investment, so better to stick with taxable bond option.
Yields on taxable vs. municipal bonds do change over time. Sometimes there is a bigger difference than others. Or, your tax bracket could change, so it’s a good idea to evaluate this decision periodically.