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Retirement Quick Tips with Ashley


Jul 8, 2020

This week I’m talking about tax-free bonds. 

Yesterday I talked about tax-free bond basics...tax-free bonds are most often issued by state, county, or city municipalities and the primary benefit of tax-free municipal bonds is their tax-free nature. 

That’s because the interest that you earn when you invest in these bonds won’t be taxed. So you could by a tax-free municipal bond with a 5% coupon or interest payment. You’ll earn $500/year on that bond and none of that will go to Uncle Sam in the form of federal taxes. 

So today, I want to dive a little bit deeper into the amazing tax perks of tax-free municipal bonds, because I think it’s also an area where a lot of investors get tripped up. 

Here’s how this works. The current top federal tax rate is 37%. If you’re married, filing jointly and you make over $622k in income this year, you’ll be in the 37% tax bracket. If you live in Oregon like I do you’ll pay 9.9% state income tax on top of that + a 3.8% net investment income tax. If you have a high income you’re looking at over 50% of that going to pay taxes. 

Enter the tax free municipal bond. If I buy a tax-free bond issued from an in-state municipality like an Oregon sewer or a local county bond that pays 4%, since none of that 4% interest is taxable, that’s like buying a CD or a corporate bond that pays 8%. Because of the tax I would pay on the corporate bond or CD interest, unless I can find something that pays over 8%, I’m better off buying the 4% municipal bond that won’t be taxed - mostly because I’m in such a high tax bracket in this example. 

Here’s the principal to follow when considering tax-free municipal bonds: the higher your income and taxes, the more these bonds make sense. They start to lose their appeal, usually when you get 2-3 rungs below the top tax rate. 

So let’s look at the same 4% tax-free bond scenario, but instead of a really high income earner with a high tax bill, let’s say your household income is $100,000. Instead of buying another taxable bond that makes 8%, you only need to find a bond that pays more than 5.8% in order to choose the other bond over the municipal bond vs. the 8% yield required if you were in the highest tax bracket. 

If you want to run the numbers for yourself based on where you live and your income to see if municipal bonds offer a good bang for the buck, just google “tax-free equivalent yield” calculator and you can enter your own personal numbers to find out if these bonds make sense for you. 

That’s it for today. Thanks for listening. My name is Ashley Micciche and this is the One Minute Retirement Tip. 

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