If you buy a $25,000 out-of-state municipal bond paying 4% interest, you’d receive $1,000 per year. If your state and local tax rates add up to say, 5%, you’d owe $50 per year (5% of $1,000) and net $950. That $50 state tax payment, though, probably would be deductible, saving you $15 in a 30% federal tax bracket. So you’d wind up with a net tax cost of $35 ($50 minus $15) and net interest income of $965, or 3.86% on a 4% bond.
With a locally-issued bond, you might get to keep all 4%, or $1,000 in interest per year. Therefore, the difference in net returns is slight; if you load up your fixed-income portfolio with locally-issued bonds, to get a bit more net yield, local economic distress may hurt the bonds’ ratings and send your bond prices lower.
Indeed, many bond experts are leery of owning bonds of one state or municipality. They find the additional state income tax is worth the reduction in risk so they prefer to have a diversified portfolio of municipal bonds from a variety of states and related entities. Investors in high-tax states may get more value from in-state bonds than investors in low-tax states. Nevertheless, some investors in low-tax states just don’t like to pay any taxes that can be avoided.
Either way, a local broker can help you find locally-issued bonds that will be completely tax-exempt. Alternatively, you can invest in single-state municipal bond funds from firms such as John Nuveen & Co., http://www.nuveen.com.
