Why Your Tax Bracket Matters More Than the Headline Yield
Municipal bonds are often described as attractive investments for high-income taxpayers. But "high income" is not specific enough. Whether a municipal bond makes sense depends on the yield available, the investor's federal and state tax brackets, and what comparable Treasury and corporate bonds are paying. For some investors, the tax benefit is not enough to overcome a lower stated yield. For others, particularly those in higher federal brackets and high-tax states, the math can flip decisively in favor of municipals.
That is why we do not view municipal bonds as inherently better or worse than taxable bonds. We evaluate the tradeoff client by client, comparing after-tax income, credit risk, duration, liquidity and the shape of the yield curve. In today's market, that analysis is especially useful because the municipal, corporate and Treasury curves are offering investors very different tradeoffs.
The differences are meaningful. Treasury yields rise from 4.21% at one year to 4.92% at 10 years and 5.50% at longer maturities. Corporate bonds pay more, reflecting additional credit risk, but their curve essentially stops getting steeper around 10 years. A 10-year corporate currently yields 6.07%, compared with 6.02% at 15 years and 6.03% beyond that. Investors receive almost no additional yield for taking substantially more duration risk.
The municipal curve looks different. Yields rise from 2.52% at one year to 3.37% at 10 years, 3.82% at 15 years and 4.60% beyond 15 years. Longer maturities bring greater interest-rate sensitivity, but unlike the corporate market, municipal investors are being paid more to extend maturity.
A Yield Isn't a Yield Until You Consider Taxes
At first glance, a 6.07% 10-year corporate yield looks substantially more attractive than a 3.37% municipal yield. For high-income investors, however, stated yields can be misleading. Corporate interest is generally subject to federal income tax, potentially the 3.8% Net Investment Income Tax (NIIT), and state income tax. Interest from qualifying municipal bonds is generally exempt from federal income tax, while qualifying in-state municipal bonds may also be exempt from state income tax. Tax-exempt municipal interest is also excluded from net investment income for purposes of the NIIT.
Taxable-Equivalent Yield = Municipal Yield ÷ (1 - Marginal Tax Rate)
Using today's 3.37% 10-year municipal yield, the taxable-equivalent yield is approximately 4.96% for an investor in the 32% federal bracket, 5.18% in the 35% bracket and 5.35% in the 37% bracket. For an investor in the 37% bracket who is also fully subject to the 3.8% NIIT, it rises to approximately 5.69%.
Where the Math Starts to Flip
The more interesting question is what tax rate makes the 3.37% municipal yield equivalent to today's 6.07% corporate yield. The answer is approximately 44.5%. An investor in the 37% federal bracket who is also subject to the 3.8% NIIT is already at 40.8% before considering state taxes. That means it takes only about another 3.7 percentage points of state income tax for the municipal bond to overtake the corporate bond on a simplified taxable-equivalent basis.
This is where the municipal market becomes particularly interesting. In Pennsylvania, with its 3.07% state income-tax rate, the simplified taxable-equivalent yield is approximately 6.00%, nearly even with corporates. In Illinois, the muni crosses over at approximately 6.21%, and the advantage grows in higher-tax states. For taxpayers actually subject to the highest marginal rates, the taxable-equivalent yield approaches 7% in New Jersey, New York and Hawaii and reaches approximately 7.34% in California. State brackets and the income required to reach those rates vary, so these are illustrations rather than recommendations for every resident of those states.
Treasuries require a slightly different comparison because Treasury interest is already exempt from state and local income taxes. Even so, for an investor subject to the 37% federal rate and NIIT, the 3.37% municipal yield has a federal taxable equivalent of approximately 5.69%, compared with today's 4.92% 10-year Treasury yield.
The Curve Adds Another Opportunity
Taxes are not the only reason municipals stand out. The steepness of their curve means investors are receiving additional yield for extending maturity. The 3.37% 10-year municipal yield increases to 3.82% at 15 years and 4.60% beyond 15 years, while corporate yields remain essentially unchanged. At a 50% combined marginal tax rate, for example, a 4.60% tax-exempt municipal yield is equivalent to roughly 9.20% on a taxable basis. That does not automatically make a long-term municipal bond a better investment. Duration, credit quality, liquidity and call provisions still matter. It does mean that investors are receiving meaningful additional compensation for accepting those risks.
It's the Yield You Keep
Today's bond market offers investors choices that were difficult to find for much of the past decade. Treasuries offer meaningful yields and exceptional credit quality. Corporate bonds provide additional income in exchange for credit risk. Municipals offer a steeper curve and, for high-income taxpayers, potentially compelling after-tax income.
For investors in the 32%, 35% and particularly 37% federal brackets, municipal bonds deserve consideration. Add the NIIT and residence in a higher-tax state, and the economics can change substantially. The right answer depends not just on the yield displayed on the screen, but on the investor's tax situation, time horizon and willingness to accept credit and interest-rate risk.
At Members' Wealth, that's why we look at fixed income through the same R.I.T.E. framework we apply across a client's financial life: Risk, Investments, Tax and Estate. Investment and tax decisions should not be made independently, because when it comes to bonds, the most important yield is not necessarily the highest one. It's the yield you get to keep.
Taxable-equivalent-yield examples are simplified illustrations and do not account for every taxpayer-specific deduction, limitation, AMT consideration, bond-specific tax treatment or state rule. Municipal securities are subject to credit, interest-rate, liquidity and call risk.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon.
These examples are for illustrative purposes only and do not represent actual client experiences. Individual results will vary based on personal financial circumstances and tax laws.
Stu Caplan is Senior Wealth Strategist at Members’ Wealth, a boutique wealth management firm that offers a comprehensive approach to serving individuals, families, business owners, and institutions.
The firm’s goal is to preserve and grow its clients’ wealth to endure over time, while thoughtfully evolving its strategy to suit an ever-changing world. With over 20 years of industry experience, Stu and the Members' Wealth team thrive on bringing clarity and confidence to clients' unique situations.
Stu received his MBA from The Robert H. Smith School of Business at the University of Maryland and his bachelor’s degree from the Eller College of Management at the University of Arizona. Stu resides in Bucks County, PA with his wife and two sons. He’s an avid golfer and is thrilled that his boys have embraced the game. He also volunteers his time as a board member of the PKD Foundation and Abrams Hebrew Academy.
To get in touch with the Members’ Wealth team today, I invite you to email info@memberswealthllc.com or call (267) 367-5453.
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The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon.
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