Generally, the higher your tax bracket, the greater the appeal of tax-exempt municipal bonds. Suppose, for example, you can earn 6% in a taxable Treasury bond. If you are in a 36% tax bracket, you’d net only 3.84%, aftertax. Thus, it would pay you to invest instead in a municipal bond yielding over 3.84%.
However, the alternative minimum tax (AMT) may change the math. Especially if you pay large amounts of state and local taxes, in relation to your income, you may be vulnerable to the AMT. The AMT is calculated by applying a lower tax rate to a greater amount of taxable income. In effect, the AMT imposes a 26% or 28% marginal rate on taxpayers who otherwise might be subject to regular tax rates as high as 39.6%. In an effective 26% tax bracket, you’d have to earn more than 4.44% on a municipal bond to top a 6% Treasury.
Thus, munis are less attractive to investors who are subject to the AMT. Check with your tax pro and consider Treasuries if you’re likely to be subject to the AMT, now or in the future.
