on December 10, 2019 Municipal bonds are very appealing to investors because of one important attribute: municipal bond interest is exempt from federal income tax. But while tax-free income sounds great, there is a catch!  The interest an investor can earn on municipal bonds is generally lower than the interest an investor can earn on a comparable taxable corporate bond.

For example, a corporate bond might pay 4% interest while a municipal bond might only pay 3% interest. Assuming the bonds are of equal risk, the spread in the interest rate between the municipal bond and the taxable bond is an implicit tax.

Which type of investment is better depends on the magnitude of the spread between the two interest rates and the investor’s marginal tax rate.  By calculating the after-tax rate of interest given the investor’s marginal tax rate, we can compare the two bonds and decide which is best.

Using our example of a municipal bond that pays 3% and a corporate bond that pays 4%, the after-tax rates of interest assuming a 12% marginal tax rate is as follows:

• Taxable bond after-tax return = 4% x (1 – 0.12) = 3.52%
• Muni bond after-tax return = 3% x (1 – 0) = 3%

At the 12% marginal rate, the taxable bond is the clear winner. Yes, the taxpayer would pay more actual tax, but the actual tax is less than the implicit tax.

At a marginal rate of 32% however, the municipal bond is more favorable.

• Taxable bond after-tax return = 4% x (1 – 32) = 2.72%
• Muni bond after-tax return = 3% x (1 – 0) = 3%

Therefore, as a general rule, investors in higher tax brackets should prefer municipal bonds, while investors in lower tax brackets will usually come out ahead if they stick to taxable bonds.