Taxable or Tax-Free Bonds

 

By Jon Flynn

 

Looking as if he were passing a gallstone, one of my clients hurried into my office recently.  He came directly over from his accountant’s office where he had just been given some bad news.  Turns out he was going to owe quite a bit more money in taxes this year then expected.  Ouch!

 

Tax season just ended and I’m finding that his circumstance is not unique.  Many seniors are noticing that they’re paying more this year in taxes than in previous years.  Why is this happening?  The main reason is that interest rates have gone up considerably over the last couple years.   For example, an investment that might have paid around 2% a couple of years ago, is now paying somewhere around 5%.   This can amount to hundreds if not thousands of dollars more of income that has to go on your tax return.

 

On one hand, it’s certainly great that we are getting more income but on the other hand, it means we are paying out more in taxes as well.  Like the old saying goes, “the more you make the more you gotta’ pay”. But isn’t there something we can we do to lessen our tax burden? 

 

My client is currently investing in taxable-bonds.  His accountant had recommended that he look into “tax-free” bonds as a possible solution for him.  Let’s take a look and see if tax-free bonds could be the answer he’s looking for.

 

Often called Municipal Bonds, tax-free bonds generally provide income to the investor that is exempt from Federal taxes.  While that sounds great, it’s also true, that in most circumstances the interest rates paid on tax-frees are usually much lower than a taxable bond of a similar maturity.

 

How can I tell which is right for me?  You can determine this by measuring something called the Taxable Equivalent Yield (TEY).  The formula for this is as follows, Tax-exempt yield / (1- tax bracket).  For example, let’s say you can get a municipal bond that pays 4 % and you’re in the 39% tax bracket.  Your TEY works out to 6.50% calculated as follows .04 / (1-.39).  This means that you would need to find a taxable bond paying 6.50% or more to work out better than a 4% tax-free bond!  Finding a 6.50% rate on a taxable bond matching the safety characteristics of a municipal bond would almost be almost impossible in today’s environment.  Generally for investors who are in a very high tax bracket, tax-free bonds typically work out better. 

 

However, for those investors who are in a low tax bracket, like my retired client, the opposite is usually true.  The typical senior is often living on a modest fixed income and thus is in a low tax bracket.  When you run the numbers using the TEY formula for many low-income seniors they are usually better served investing in taxable types of investments rather than their tax-free counterparts.  So even though you end up having to pay taxes, the bottom line is you’ll receive more after-tax income.  Remember, it’s not the interest rate that’s important - it’s what you keep after taxes. 

 

The TEY calculation showed my client that it was best to stay put with his current taxable investments. Although, he still left with the same painful look on his face as when he came in, he left reassured that he was doing the right thing.

 

Everybody situation is different and arriving at solutions can get complicated.  So always consult with financial, legal, and tax professionals before making any decisions.

 

 

Jon Flynn is a Certified Financial Planner ^TM and owner of Flynn Financial in Eynon. He is a Representative of Securities America, Inc., Member FINRA/SIPC and of Securities America Advisors, Inc. Flynn Financial and Securities America are unaffiliated.   Mr. Flynn can be reached at 570-876-5015.