Would A 4% Taxable Equivalent Return Make You A Bond Investor?Advisor Perspectives
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Among advisors, 4% is the magic number for retirement planning. We are told that the only way to achieve this return is to allocate a substantial amount to risky assets, such as stocks, real estate and alternative investments. It is possible, however, to earn a return of 4% from the lowly, misunderstood tax-exempt municipal bond.
To broaden your understanding of the meaning of return, focus on the distinction between a before-tax and after-tax investment. Investments that provide before-tax returns include stocks and stock-funds, corporate and Treasury bonds and bond funds, REITS and certificates of deposit.
An after-tax return is what an investor can spend in the stores or on-line – e.g. gifts and trips. The interest returned on tax-exempt municipal bonds (“muni bonds” hereafter) is an after-tax amount. The interest is paid twice a year and is swept into your money market account. It does not make a sound. It does not go ka-ching! There is no nightly news report or app alerting you to the increase in your wealth.
Interest payments are so quiet that some of our clients need reminding that the cash coming into their money market account is tax-exempt. How do you know it is actually tax-exempt? It will show up on page one of your federal Form 1040 on line 2a as tax-exempt interest. It is reported, but is not included as taxable income.
If you are in a high federal income tax bracket, you will benefit significantly from owning muni bonds. If you are subject to a high state-tax burden, muni bonds may further enhance your after-tax return.
To understand the true financial and tax value of muni bonds, you must dive into some technical concepts. The thought of saving taxes might spur you on. You will learn a new financial calculation and some tax rules. But, all you need to come away with is that muni bonds will lower your taxes and help you achieve your financial goals.
Investing for the highest after-tax return
You must view every investment through a tax lens: How will the return from this investment be reported on my tax return?
To make this calculation, you must first determine your highest federal income tax bracket. This is called your marginal tax bracket, the tax rate on your last dollar of taxable income. To find out your marginal tax bracket, type “marginal tax bracket calculator” into a search engine or ask your accountant.
Federal tax brackets range from 10% to 37%. Once you know your marginal tax bracket you can then compare the return you would get on an investment that is taxable with one that is not.
Muni bond interest is not subject to federal income tax (with some exceptions). Therefore, to appreciate the value of a tax-exempt investment to you and compare it to a taxable one, we use a calculation called the taxable equivalent return, which is based upon your marginal tax bracket.
The following formula makes the comparison and equates the return on a taxable investment and a muni bond:
Taxable investment rate x (1 – your top marginal tax bracket) = Tax-free bond rate
Read the full article here by Stan Richelson and Hildy Richelson, Advisor Perspectives