Heard of triple tax exempt and want to rush to getting some munis?Not so fast!Munis low yield may badly hurt performance of many popular types of accounts and individual investments.So what are they?Who might get benefit from them?
Munis or municipal bonds are debts issued by State,local governments,territories,and state or local agencies.
Of all munis are there about 45% General Obligation bonds (G.O. bonds),45% Revenue bonds and 10% special others.
G.O. bonds are debts backed up by full faith,credit,and taxing power of the issuer.Every time a G.O. bond issuance is announced that means tax payers in that municipality just take on a debt and might have to pay a little more tax to finance it.
Revenue bonds are debts backed by a specific source of revenue and consider self-supporting debts.
Other special types like:
IDBs bonds:Industrial Development Bonds.The debt is backed by both the local government and the private company who leases the facility.Credit rating is mostly placed on the company.
Double-barreled bonds:backed up mostly by revenue (like revenue bonds) but also by taxing power (like G.O. bonds) as a second source.
Special tax bonds: backed by excise taxes (cigarette,liquor,gas)
To evaluate a muni’s credit rating companies usually look at the debt per capita-public debt burden per resident-of that municipality for G.O. bonds,the lower the better.For revenue bonds they watch the ratio of net revenue over debt service requirement,the bigger the better.Most munis are investment graded and some AAA rated if they are insured by insurance companies but defaults (or technically in) may still occur sometimes like New York in 1975 and Orange County,CA in 1995.
Taxation: tax applied to munis is quite complicated.It is best to check with personal tax adviser before investing in munis since commitment is another consideration.In general,interest income is exempt from federal,and state and local for its residents(1 or more years of residency,residency rule is not required by Puerto Rico,Virgin Islands).
To see if the tax exempt is worth, a formula is usually used for yield comparison because munis’ yield is typically low;for example,a muni yields 5% and a comparable corporate bond yields 8% for a tax bracket of 20% and a tax bracket of 30%:
Equivalent non-exempt yield = muni yield/(100%-tax bracket)= 5/80= 6.25%.
Equiv. non-exempt yield = muni yield/(100%-tax bracket)= 5/70 = 7.14%.
Clearly,in both cases (low or high tax bracket)the high yield of corporate bond still outweighs the exempt advantage.Because taxable 8% bond pays more than tax exempt 5% bond.
Capital gains are subject to federal tax.
The Tax Reform Act of 1986 defines 3 different kinds of munis in which the type of “Public Purpose” is exempt,”Qualified” subject to Alternative Minimum Tax (AMT-25-28%),and “Non-Essential” subject to both AMT and Regular Income Tax.
The advantage of triple tax exempt is no meaning to many popular tax-exempt or tax-deferred investment like Retirement and pension plans 401K,IRAs,403(b),College and Higher Education 529(b),Coverdell,to name a few.In contrast,lower yield may hurt performance.
Mostly,munis buyers are banks and financial institutions because they can take advantage of the 80%-interest-cost-deduction tax rule for “bank qualified ” munis;on the other hand,while banks hold yielding munis they still can used the bonds as leverage for cash need,marketability or liquidity is not a trouble.