Taxable vs. Tax Exempt Bonds
When investing in bonds, one of the most important considerations is whether you want to invest in those with interest that is taxable or those that are considered tax exempt bonds.
While it may seem that opting for bonds that are tax exempt is the best option, this is not always the case.
Corporate bonds are one of the most common bond types available. These bonds are available as either secured or unsecured and have varying levels of risk depending on whether they are backed by the company’s assets or overall creditworthiness.
Corporate bonds often have higher interest rates than other types of bonds, but this income is taxable as ordinary income. This means that any income generated from the interest of the bond will be subject to both state and federal taxes.
Government bonds, which are those that are issued by federal governments, are the safest types of bond investments. Federal agencies or the treasury department generally issues these bonds. The interest earnings from these bonds are subject to federal taxation, but are exempt from local or state taxes.
Municipal bonds are issued by local government or municipal authorities and are exempt from federal taxes.
While these are considered tax-free bonds in some situations, this status can vary based on the laws in a particular state. Generally, bonds issued to residents in a state are exempt from that state’s income taxes. However, if an investor chooses municipal bonds from another state, he or she will be liable for paying taxes on the
However, if an investor chooses municipal bonds from another state, he or she will be liable for paying taxes on the interest generated income.
It is also important to understand that each state has its own rules that determine whether the income is taxable. For example, Texas, Alaska, Nevada, Florida, South Dakota, Wyoming and Washington do not have income taxes, which results in tax-free bonds regardless of the issuing state.
There are also states that tax both in state and out-of-state bonds. These states include Illinois, Iowa, Oklahoma, Utah and Wisconsin. If you reside in these states, you will likely be required to pay taxes on bonds issued by the state as well as those from other states.
Taxable Equivalent Yield
When deciding between taxable and tax exempt bonds, it is important to consider and calculate the taxable equivalent yield. This calculation, which is based on your income tax bracket, will help you determine which bond option will generate the highest yield.
The taxable equivalent yield assists investors by providing insight into the amount of income that will need to be generated by a taxable bond to make it equivalent to the yields provided by tax-free bonds.
To determine the taxable equivalent yield, investors will need to divide the yield of the tax exempt bond by one minus their marginal income tax bracket. This will provide the overall yield required from a taxable bond in order for it to be an equivalent investment option.