Tax Free Bond Rate

Nothing is certain except death and taxes? Well death certainly, but don't be so sure about taxes because there is such a thing as tax free bonds.

The tax free bonds are primarily limited to Municipal Bonds which are sometimes called "munis," and the tax exempt status of these bonds can translate to a very secure investment that can perform as well or better than other investments that involve much more risk.

Municipal bonds are basically an IOU issued by state and local governments to build projects or fund government operations. There are two advantages to these kinds of bonds. One is that defaults are extremely rare and the other is they are exempt from federal income taxes, and when purchased in the same state the buyer lives in can also be exempt from state and local taxes.

Naturally what determines how much tax free bonds can earn as opposed to other investments depends on the tax free rate as opposed to other rates that can be earned. And while that may sound complicated figuring the tax free rate is rather simple.

The question then becomes how can an investor be sure that a tax free bond will actually earn as much or more than other stocks and bonds? Of course the answer requires doing the math but fortunately in this case the formula is actually fairly simple.

The taxable equivalent of municipal bond uses this formula. Take the individual's marginal tax rate (or the percentage they currently pay in taxes) and subtract that from the number 1. The taxable equivalent is arrived at by then dividing the Municipal Bond yield from the tax rate subtracted from 1.

Hypothetically let's assume the individual is in the 30% tax bracket. Subtract that tax rate from 1, or 1-.30=.70. Then take the expected yield of the municipal bond and divide your tax rate by the bond yield. If the bond yield is 2.8% it would look like this.

0.028 / (1 - 0.30) = 3.94%

What this means is if the municipal bond yield is 2.8% the actual return will be the equivalent of a taxable bond with a yield of 3.94% and the return can be even more attractive if the bond is also exempt from state and local taxes.