Tax Free Bonds Versus Taxable Bonds

Investing in bonds is a good way to earn reasonable returns, but how do you know whether a tax free bond or a taxable bond is the best investment?

A bond is simply the lending of money to another party. Bonds are issued as security for the money loaned. Most bonds are either corporate or governmental. They are traditionally issued in $1,000 face amount. Interest is paid on an annual or semi-annual basis.

Corporate bonds are taxable, while some governmentals are non-taxable. Municipal bonds and I-bonds (issued by the U.S. Treasury) are non-taxable.

How do you decide to invest in taxable or non-taxable bonds? Two variables play into the decision; interest rate and marginal tax rate. The interest rate is what the bond will pay you. Marginal tax rate is the percentage you will pay on the next dollar earned.

In order to make an informed decision about the proper investment, we have to do some math. I know, you don?t like math and formulas, but this one is not too complicated.

For example, most of us will fall in the 25% federal income tax rate, and let?s suppose that our state income tax rate is 3%. That gives us a marginal tax rate of 28%. We subtract .28 from 1.00 leaving .72 or 72%.

This means that a non-taxable interest rate of 3.6% would be the same return as a taxable rate of 5%. That was derived by multiplying 5% by 72%. So any non-taxable return greater than 3.6% would be preferable to a taxable rate of 5%.

The complicating factor is the rating of the bond. Bonds are rated on the credit quality of the issuer. Higher quality bonds have lower interest rates than higher risk bonds. Non-taxable bonds are generally high quality. The determination of whether to take low rated high return bonds versus high rated low return bonds depends upon the individual tolerance for risk.

The method for determining whether to buy non-taxable or taxable bond is really not that daunting, and should be used anytime you are purchasing bonds.