4.1 Municipal Bond Basics
Municipal bonds are issued by states, cities, counties, and public authorities. Their primary selling feature is federal tax exemption on interest income.
Key FINRA Exam Takeaways
- Interest paid on state and local municipal bonds is 100% EXEMPT from federal income taxes.
- If the investor resides in the issuing state, interest is typically exempt from state and local taxes as well ('triple tax-free').
- Capital gains realized on municipal bonds are FULLY TAXABLE.
- Tax-Equivalent Yield (TEY) = Municipal Yield ÷ (1 - Investor Marginal Tax Bracket).
- Suitable primarily for high-income investors in high tax brackets; NOT suitable for IRAs or 401(k) plans.
Tax-Equivalent Yield (TEY) Formula
To compare a tax-free municipal yield to a taxable corporate yield: TEY = Muni Yield ÷ (1 - Tax Rate). Example: A 4% municipal bond for an investor in a 35% tax bracket provides a TEY of 4% ÷ (1 - 0.35) = 4% ÷ 0.65 = 6.15%.
The IRA Unsuitability Rule
Because retirement accounts (Traditional IRAs, 401ks) already provide tax-deferred growth, placing a tax-free municipal bond inside an IRA squanders the tax advantage while forcing the client to accept a lower yield. This is a severe suitability violation on FINRA exams.
Tax-Equivalent Yield (TEY) Step-by-Step
An investor in the 32% federal tax bracket is evaluating a 4.5% municipal bond. What taxable corporate bond yield must they earn to match this municipal bond?
- Step 1: Identify municipal yield = 4.5% (0.045).
- Step 2: Calculate after-tax retention rate = 1 - 0.32 = 0.68.
- Step 3: TEY = 4.5% ÷ 0.68 = 6.6176%.
An investor in the 37% federal tax bracket is considering a 3.8% municipal bond. What is the tax-equivalent yield (TEY) of this bond?