It's not what you earn from an investment that's important; it's what you keep after the tax collectors extract their vigorish. After-tax return is the name of the game.
Highlights:
Taxes matter and it's starting to look like taxes are going up.
Most, but not all, bonds issued by state and local governments are exempt from federal income taxes.
Depending on where you live income may be double or even triple tax-exempt (meaning local, state, and even federal tax-exempt)!
Attention Investors: After-tax returns matter! Did you know that some investment earnings are exempt from certain taxes? That's even more important now that the government has targeted investment income for higher tax rates (Oh No, Say it Ain't So, Joe!)
Many states exempt income from state issuers from state and even local income taxes which can make these issues particularly attractive (Hello, California and New York - but you’re not alone!)
Municipal Bonds do more than just pay you; investing directly in munis can be both personally and financially rewarding. Munis, offered by state and local governments, perform yeoman's work for your community and pay tax-free income to you. Municipal bonds are used to fund your local infrastructure which means you can really invest close to home.
Don't let Wall Street use lots of mumbo jumbo lingo to confuse you. To calculate your simple after-tax return for comparison, simply multiply the stated return by one minus your highest applicable tax rate (1 - Tax Rate %). With a tax-exempt municipal bond, the stated rate is the after-tax rate - compare away.
Example of Corporate Bond:
You invested $1,000 of a corporate bond that pays a 5% annual coupon.
Let's assume you're married, live in New York, and have a combined income of $250k.
Based on your income and marriage status, your highest marginal tax rate is 24%.
So, your after-tax return for this corporate bond would be 3.8%.
Example of a New York Municipal Bond:
You invested $1,000 of a New York Municipal bond that pays a 4.25% annual coupon.
Let's assume you're married, live in New York, and have a combined income of $250k.
Based on your income and marriage status, your highest marginal tax rate is 24%.
So, your after-tax return for this municipal bond would be 4.25%.
While the corporate bond yielded 0.75% more than the municipal bond, ultimately, you earned 0.45% more by investing in the municipal bond than the corporate bond.
So, remember, to increase your actual take-home returns (aka: after-tax returns), you have to look at how taxes affect your investment returns. You can't just look at the gross returns. Be savvy and learn how to make the system work for you, instead working for the system.
Yes, It's really that straightforward.