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CHAPTER 7

Let’s consider a hypothetical example of the Smiths. Currently, they are in the 35-percent tax bracket. They are considering investing $100,000, but are unsure of whether they would benefit from munic- ipal bonds. The bonds they are thinking about pay an interest rate of 6 percent. They are also looking at a bank CD for this money, which pays 8.2 percent. Which investment could earn them a higher after- tax return? The Smiths would earn 6 percent after tax from their muni bond, but they would only earn 5.33 percent after tax from the bank CD. Therefore, the muni bond would earn a greater after tax return for the Smiths. (See Tables 7.2 and 7.3 for comparisons with the updated tax brackets.)

(1 – tax bracket) taxable yield = tax-free yield (1 – .35) 8.2% = 5.33%

When considering the tax implications of purchasing municipal bonds versus other fixed-income investments, also determine whether you will be paying state and local taxes on the interest and capital gains. Usually, the muni bonds will be exempt from state and local taxation. These are sometimes referred to as “triple-tax-free municipal bonds” because of the income tax exemptions on the inter- est and sometimes on the capital gains.

For example, the Smiths have a state income tax rate of 4.4 per- cent, no local income tax rate, and they itemize their deductions. Their effective state rate is 4.4 x (1 - .35) = 2.86 percent. Their total tax rate is 37.86 percent. In this case, the municipal bond they are considering would be free from state income tax, as well as federal income tax.

However, the bank CD yield of 8.2 percent isn’t exempt from any taxes. Therefore, their after-tax rate on the muni bond remains 6 per- cent, whereas the after-tax rate of the bank CD is 5.095 percent.

(1 – .3786) 8.2% = 5.095% Amounts are hypothetical.

However, if the Smiths don’t itemize, or if the deductions are mostly phased out on their federal income tax return, and the state

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