Income, tax, and where to hold it
A muni yielding 3.5% can beat a corporate at 5%, because the client keeps all of the first and part of the second. The break-even tax rate turns the comparison into one question.
- Gross a tax-free yield up to its taxable equivalent
- Find the tax rate at which a muni and a corporate bond tie
- Compare after-tax income in dollars, with and without state tax
- Say why a muni inside an IRA is a mistake
The intuition
A municipal bond yields 3.5%, free of federal tax. A comparable corporate bond yields 5%. For a client in the 32% bracket the corporate pays 5% × (1 − 32%) = 3.4% after tax, less than the muni. Put the other way, the muni's taxable-equivalent yield is 3.5% ÷ (1 − 32%) = 5.15%: the corporate would have to yield that to match it.
The comparison collapses to one number, the break-even tax rate: 1 − muni yield ÷ corporate yield, here 30%. A client above it should hold the muni; below it, the corporate. That is why munis are a high-bracket product, why adding state tax for an in-state muni raises the equivalent yield further, and why holding a muni inside an IRA, where nothing is taxed until withdrawal, throws the tax break away.
Taxable-equivalent yield = muni yield ÷ (1 − tax rate). After-tax corporate yield = corporate yield × (1 − tax rate). Break-even tax rate = 1 − muni yield ÷ corporate yield. With state tax on the corporate bond, use federal + state.
Why it works
- The conventions here: an in-state municipal bond exempt from federal and state income tax against a taxable corporate bond of similar credit and maturity. Tax rates are marginal. State tax is simply added to federal. Yields are annual, held to maturity, with no credit or call differences.
- Gross up or net down; the answer is the same. Divide the muni yield by (1 − t) to compare before tax, or multiply the corporate yield by (1 − t) to compare after. Pick one and be consistent.
- The break-even rate is the whole decision. 1 − muni ÷ corporate. Above it the tax saved outweighs the lower yield; below it, the lower yield costs more than the tax it saves.
- State tax raises the bar for the corporate, so an in-state muni's equivalent yield rises with the combined rate. The additive shortcut is standard; the true combined rate is usually a little lower because of deductions.
- Munis belong in taxable accounts. Inside an IRA every withdrawal is taxed as ordinary income anyway, so the muni's exemption is wasted and the client simply earns the lower yield.
- The general principle is asset location: tax-inefficient assets in sheltered accounts, tax-advantaged or tax-efficient ones in taxable accounts. It can add return without changing the allocation.
| Taxable-equivalent yield: 3.5% ÷ (1 − 32%) | 5.15% |
| Corporate after tax: 5% × (1 − 32%) | 3.40% |
| Break-even tax rate: 1 − 3.5% ÷ 5% | 30% |
| After-tax income on $500,000: $17,500 muni against $17,000 corporate | $500 a year in the muni's favour |
| With state tax, combined 37%: 3.5% ÷ (1 − 37%) | 5.56% |
At 32% the client is two points above the 30% break-even, so the muni wins narrowly. Add state tax and it wins clearly.
The formulas
Gross the tax-free yield up.
Net the taxable yield down.
Above it, the muni pays more after tax.
The additive shortcut for an in-state muni.
Worked example
After-tax income from each bond in dollars, then the difference. The sign says which bond this client should hold.
See it move
Same client. Change the two yields, the federal bracket, the state rate and the amount invested.
- Raise the tax rate. The corporate's after-tax yield falls and the muni's equivalent yield rises; the break-even rate does not move, because it depends only on the two yields.
- Raise the corporate yield. The break-even rate rises: the muni needs a higher bracket to win.
- Raise the muni yield. The break-even rate falls and the equivalent yield rises.
- Raise the state rate. Only the readout with state tax moves, and it rises.
Run it backwards
Two yields are known. Above what marginal rate does the muni pay more after tax?
Set corporate × (1 − t) equal to the muni yield: t = 1 − muni ÷ corporate. It is the yield ratio, taken from one.
The follow-up puts the client's bracket against it, which is the entire recommendation.
Traps
Say it in the interview
“Should this client hold municipal or corporate bonds?”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- Taxable-equivalent yield = muni ÷ (1 − t); after-tax corporate = corporate × (1 − t).
- Break-even rate = 1 − muni ÷ corporate; the client's bracket against it is the decision.
- State tax raises the equivalent yield of an in-state muni.
- Munis in an IRA waste the exemption: asset location.