Municipal Bonds Explained: Tax-Free Income and Taxable Equivalent Yield

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Do you want to potentially boost your income without paying extra taxes? Municipal bonds might help municipal bonds or Muniz pay interest. That’s usually federal tax free to keep more of what you earn compared to taxable bonds. However, investors need to understand the concept of taxable equivalent yield. It compares what a taxable bond would need to pay to match the after tax return of a muni.

Here’s how to calculate it. Divide the muni yield by one minus your federal marginal tax rate. For example, if the muni pays 3% and your federal rate is 35% of the taxable equivalent, yield is about 4.62%. Start another way. A taxable bond would need to pay 4.62% to match the 3% muni yield after tax. For someone in the 35% marginal rate, and as an added bonus, the municipal bonds issued by the state where you reside are also generally exempt from your state income tax.

If you’re in a higher tax bracket, munis can be a smart way to increase your net income, even if the rates look lower on paper. Interested in how municipal bonds might fit your income strategy? Talk to an advisor who can help you elevate your options and keep more of your income.