Bond investors who wish to decrease their tax burden can pursue income that is free of federal, state, and even local taxes. Municipal bond funds earn income free of federal tax. State municipal bond funds generate income exempt from federal, state, and sometimes local taxes for residents of that state.
Investors in higher federal tax brackets or residents of high-tax states can realize a significant overall tax advantage by including tax-free bond funds in their portfolio. Although tax-free bond funds typically yield less than their taxable counterparts, investors accept a lower yield because they don't have to pay federal (and perhaps state and local) taxes on the income. Depending on the investor's tax bracket, tax-free bonds may provide higher after-tax income. The following chart shows that as your effective tax rate rises, the value of tax-free yield to you also increases.
| Federal Tax-Exempt vs. Taxable Yield | |||||
| Your Taxable Income (2008)* |
A Tax-Exempt Yield of: | ||||
| 3% | 4% | 5% | 6% | 7% | |
| Federal Tax Rate | Is Equivalent to a Taxable Yield of: | ||||
| 25.0% | 4.00% | 5.33% | 6.67% | 8.00% | 9.33% |
| 28.0% | 4.17% | 5.56% | 6.94% | 8.33% | 9.72% |
| 33.0% | 4.48% | 5.97% | 7.46% | 8.96% | 10.45% |
| 35.0% | 4.62% | 6.15% | 7.69% | 9.23% | 10.77% |
Effective 1/1/08
*This chart is for illustrative purposes only and does not represent the performance of any specific security. Net amount subject to federal income tax after deductions and exemptions.
To learn more about tax-free investing, whether it’s right for you, and how to develop a tax-free investment strategy, read the following Insights reports:
- The Basics of Tax-Free Investing
- Investing in High-Yield Municipal Bonds
- Tax-Free Equivalent Yield Calculator
Investors have become increasingly aware of the alternative minimum tax. This provision was originally intended to ensure that Americans with high incomes could not avoid paying taxes. Because the income levels set to trigger the AMT have not been adjusted for inflation, more and more taxpayers have been subject to the AMT. T. Rowe Price recommends that while investors should consider the impact of the AMT, it should not be the primary factor in their investment decisions. There are a number of things you can do to minimize your AMT liability, including choosing AMT-free municipal bonds, spreading any gains over several years, and planning your income and deductions.
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