State and local governments issue municipal bonds (munis) to pay for public projects and services. Municipal securities remain one of the best tax shelters available for individual investors, and their appeal for those with relatively high incomes is even greater with income tax rates high at both the federal and state levels. The primary advantage of municipal securities, of course, is that the incomes earned on most of them is free of federal income tax.

In addition, most states do not tax income earned on their own debt obligations, so investors in those states avoid federal, state, and possibly local income taxes, making the income double- or triple-tax-free. With these tax advantages, it's not surprising that individual investors, either directly or through mutual funds, hold almost three-quarters of all municipal bonds.

Comparing Tax-Exempt and Taxable Yields

In assessing whether you should invest in municipal bonds, you should compare their yields with those available on taxable alternatives of comparable maturity and quality to see which investment might provide greater after-tax income. Keep in mind that stated yields on munis are lower than on taxable bonds since income from them is exempt from federal, and possibly state and local, income taxes. Therefore, the comparison must account for taxes paid on income earned on government, corporate, and other taxable issues. Use the calculators below to compare taxable yields to munis.

Calculator 1
Calculating Taxable-Equivalent Yields
For Out-of-State Municipal Bonds or National Muni Bond Funds
		Example	Your Calculation
Line 1.	Enter the tax-free yield.	5.0%
Line 2.	Enter your federal marginal income bracket, expressed as decimal.	.35
Line 3.	Subtract the bracket on line 2 from 1.00. (1.00-.35=.65)	.65
Line 4.	Divide the tax-free yield on line 1 by line 3 to find the taxable-equivalent yield. This represents the yield you would need to earn on a taxable security to equal the tax-exempt yield. (5.0 ÷ .65 = 7.692%)	7.692%
NOTE:	If you are calculating the taxable-equivalent yield for a U.S. Treasury bond or bond fund, or other direct government obligations, complete steps 5 through 8 to account for the exemption of interest on such issues from state and local taxes.
Line 5.	Enter your state and local marginal income tax rate, expressed as a decimal. (9% = .09)	.09
Line 6.	Multiply line 5 by line 3, to reflect the deduction of state and local income taxes on your federal return.* (.09 x .65 = .059) (If you do not itemize deductions, simply enter rate on line 5.)	.059
Line 7.	Subtract rate on line 6 from 1.00. (1.00 - .059 = .941)	.941
Line 8.	Multiply yield on line 4 by rate on line 7. (7.692% x .941 = 7.24%) This represents the yield you would need to earn on a Treasury security to equal the tax-exempt yield on line 1.	7.24%
* This formula does not reflect the phase-out of deductions for state and local taxes and other items for taxpayers with adjusted gross income (AGI) above $132,950 in 2001. These deductions are reduced by an amount equal to 3% of AGI over the threshold amount but not to exceed 80% of the deductions.

Calculator 2
Calculating Taxable-Equivalent Yields
For In-State Municipal Bonds or Single-State Muni Bond Funds
		Example	Your Calculation
Line 1.	Enter the tax-free yield.	5.0%
Line 2.	Enter your federal marginal income tax bracket, expressed as decimal.	.35
Line 3.	Subtract the bracket on line 2 from 1.00. (1.00-.35=.65)	.65
Line 4.	Enter your state and local marginal income tax rate, expressed as a decimal. (9% = .09)	.09
Line 5.	Multiply line 4 by line 3, to reflect the deduction of state and local income taxes on your federal return.* (.09 x .65 = .059) (If you do not itemize deductions on your federal return, simply enter rate on line 4.)	.059
Line 6.	Add rates on line 2 and line 5. (.35 + .059 = .409)	.409
Line 7.	Subtract rate on line 6 from 1.00. (1.00 - .409 = .591)	.591
Line 8.	Divide tax-free yield on line 1 by line 7 to find the taxable-equivalent yield. (5.0 ÷ .591 = 8.46%)	8.46%
* This formula does not reflect the phase-out of deductions for state and local taxes and other items for taxpayers with adjusted gross income (AGI) above $132,950 in 2001. These deductions are reduced by an amount equal to 3% of AGI over the threshold amount but not to exceed 80% of the deductions.

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