The key benefits of investing in Treasury notes or money market mutual funds are liquidity and safety. However, there is another substantial advantage provided by certain money market instruments known as’munis’or short-term municipal securities: federal tax savings, which are especially favorable to people in a high federal tax band.
Local securities are interest-bearing debt instruments issued by state and municipal governments to cover running expenses, some tax-exempt institutions such as universities and nonprofit hospitals, and to transfer financing to corporations and people on occasion. The tax-exempt status of municipal bonds not only exempts purchasers from paying taxes on interest income, but also enables government issuers to borrow at lower interest rates.
Municipal securities are classified as short-term investments in general; nonetheless, they are technically short-term if their maturities are shorter than three years. There are numerous types of notes in the universe of short-term munis, including bond anticipation notes, tax anticipation notes, and revenue anticipation notes. The word of the day in all three is anticipation, which refers to how the notes give immediate, short-term funding to assist bridge any financial gaps until the government gets revenues through bond issuance, taxes, or government-sponsored, revenue-generating initiatives. (For further information, see The Fundamentals of Municipal Bonds.)
Tax-exempt commercial paper and variable-rate demand obligations are two types of longer-term munis that enable state and local governments to finance major, long-term projects at short-term rates. Swaps, municipal preferred stock, and floaters/inverse floaters are three more forms of long-term munis that allow issuers to borrow at long-term fixed rates while giving investors with floating-rate, short-term debt.
Individual Tax Rates
An investor would buy munis only if their marginal federal tax was high enough that they needed protection from it. Munis have lower yields than other taxable assets, so investors must decide if the tax savings are big enough to offset the lower return.
As a result, muni yields are often expressed in terms of the taxable interest rate necessary to generate the same after-tax interest rate. The following formula is used to calculate the equivalent taxable interest rate for munis:
R(te) = R(tf) / (1 – t)
R(tf) = the rate paid on the tax-free muni
t = the investor’s marginal tax rate
R(te) = the taxable equivalent yield for the investor with a marginal tax rate of “t”
Assume you have a marginal tax rate (t) of 25% and are contemplating a tax-free municipal payment of 5%. The following is the formula for calculating the muni’s after-tax interest rate:
R(te) = 0.05 / (1 – 0.25)
R(te) = 0.067
To be more advantageous than the muni, the taxable investment must yield more than 6.67%.
Additional Tax-Exemption Benefits
Income from munis may be excluded from state income tax as well as federal income tax if the investor acquires securities issued by their home state or municipalities situated in their home state. If the investor obtains this twofold tax exemption, they compute the equal taxable rate using a modified version of the previous formula:
R(te) = R(tf) / (1 – [tF + tS(1 – tF])
tF = the marginal federal tax rate of the investor;
tS = the marginal state tax rate of the investor
Assume everything remains the same as in the previous case, except that the muni provides you a twofold tax exemption and you have a 10% state income tax rate:
R(te) = 0.05 / (1 – [0.25 + 0.10(1 – 0.25])
R(te) = 0.074
The corresponding taxable yield on a 5% muni is now 7.4%.
Investing in Munis
Individuals may buy munis directly from a securities dealer, but a tax-exempt money market fund is a more common option. Money market mutual funds are often extremely large pools of money market assets, which may include solely certain munis, a mix of munis, or a mixture of munis and other money market instruments. (For further information, see Introduction to Money Market Mutual Funds and A Long-Term Mindset Meets the Dreadful Capital Gains Tax.)
Downfalls of Munis
Because the money earned by munis is heavily impacted by tax policy, they are partly sensitive to the current government’s taxation philosophy. Prior to the 1980s, munis were immensely popular investments because rich persons were subject to higher marginal tax rates. The Economic Recovery Tax Act of 1981 dropped the top marginal tax rate from 70% to 50%, and the Tax Reform Act of 1986 reduced it even more to 33%.
The decrease in marginal tax rates reduced the appeal of munis, forcing governments to increase muni rates disproportionately higher than other taxable instruments. As a result, state and municipal governments lost some of the advantages of formerly affordable debt financing and were less eager to issue short-term municipal securities to finance different projects or continuing operations.
The Bottom Line
Even if the cause and popularity of munis has waned since their pre-1980s heyday, they continue to play a vital role in the portfolios of select investors. For rich investors, munis may dramatically reduce their tax burden, particularly if they qualify for double tax exemption. Short-term municipal securities may be an appealing addition to a well-diversified portfolio, particularly if the portfolio holder is in the high echelons of the federal marginal tax rate.
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