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With the continued fluctuations in the stock market and bank CDs rates at almost an all time low, one of the most common questions currently being asked is whether or not one should consider a tax-free investment, i.e. municipal bonds. It might be an attractive alternative.
Two factors to consider when answering this question are: your investment objectives and your marginal tax rate. Assuming that a tax-free investment could fit into the parameters of your investment plan, the next step is to determine if the yield/return would be favorable.
There is a simple formula which will help you to analyze tax-free yields. Simply divide the tax-free yield by 100 minus your marginal tax rate. This will enable you to convert the tax-free yield into its “taxable equivalent” yield. Let’s look at an example. Suppose that you are in the 28% tax bracket, and you can purchase a tax-free bond yielding 5%, which is about the going rate today. Would that be a good deal? The way to find out is to use the formula and calculate the tax-free bond’s taxable equivalent yield. Here’s how to do it: you would divide 5 (the tax-free yield) by 72 (100- marginal tax rate of 28). The result would be 6.94%. This means that you would have to find a taxable investment such as a bank certificate of deposit (CD) yielding 6.94% in order to receive the same after-tax return that the 5% tax-free bond would provide. I don’t know of any CDs paying anywhere near that amount. Needless to say, the higher your marginal tax rate, the more attractive tax-free bonds become.
Municipal bonds are the only true “tax-free” investment. The most common ways that they may be purchased include individually, in an open-end or closed-end fund, in an electronically traded fund (ETF) or in a unit trust. There are certainly other factors one should consider before purchasing municipal bonds, such as the quality of the bonds, their rating, whether or not the are insured, their maturity date, if they are callable, and of course your own tolerance to interest rate and default risk. Municipal bonds do fluctuate in value with the rise and fall of daily interest rate movement, however, that doesn’t affect the interest you’re getting paid, and at maturity you should receive all of your principal back.
Since everyone’s tax and investment situation is unique, I certainly recommend that you consult your investment and/or tax advisor before making a final decision.
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