Weighing The Tax Benefits Of Municipal Securities

The primary advantages attracting an investor to Treasury bills or money market mutual funds are their liquidity and safety. But there is another significant benefit offered by particular money market instruments known as 'munis' or short-term municipal securities: federal tax savings, which are particularly beneficial to those who fall within a high federal tax bracket.

Municipal securities are interest-paying debt securities issued by state and municipal governments to finance operating expenditures, to fund certain tax-exempt entities such as colleges and nonprofit hospitals, and occasionally to provide funds to firms and individuals. The tax-exempt status of munis not only relieves buyers from paying tax on the interest income, but also allows the government issuers to borrow at favorable rates.

Municipal securities are generically categorized as short-term investments; however, they are only technically short-term if they have maturities of less than three years. Within the universe of short-term munis there are several categories of notes, including bond anticipation notes, tax anticipation notes, and revenue anticipation notes. The key word in all three is anticipation, which refers to how the notes provide immediate, short-term funds to help bridge any financial gaps until the government receives proceeds from bond issues, taxes, or government-sponsored, revenue-producing projects. (For further reading, see The Basics Of Municipal Bonds.)

Within the universe of longer-term munis there is tax-exempt commercial paper and variable-rate demand obligations, which allow state and municipal governments to fund their large, long-term projects at short-term rates. Three additional types of long-term munis are swaps, municipal preferred stock, and floaters/inverse floaters, all of which enable issuers to borrow at long-term fixed rates, while providing investors with floating-rate, short-term debt.

An investor would purchase munis only if he or she had a heavy enough marginal federal tax to seek protection from it. Munis offer lower yields than other taxable securities, so the investor must determine whether his or her tax savings are significant enough to make up for the lower yield.

The yields on munis are therefore often articulated in terms of the taxable interest rate that would be required to provide the same after-tax interest rate. The formula for determining the equivalent taxable interest rate for munis is the following:

R(te) = R(tf) / (1 – t)

Where:
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"

For example, let's say that you have a marginal tax rate (t) of 25%, and you are considering a tax-exempt muni paying 5%. Here is the calculation of the muni's after-tax interest rate:

R(te) = 0.05 / (1 – 0.25)
R(te) = 0.067

To be more favorable than the muni, a taxable security would have to offer you a yield higher than 6.67%.

In addition to being exempt from federal income tax, the income from munis may also be exempt from state income tax if the investor purchases securities issued by his or her home state or by municipalities located in his or her home state. If the investor receives this double tax exemption, he or she uses a revised version of the above formula to calculate the equivalent taxable rate:

R(te) = R(tf) / (1 – [tF + tS(1 – tF])

Where:
tF = the marginal federal tax rate of the investor;
tS = the marginal state tax rate of the investor

Say everything is still the same as the above example, except that the muni offers you double tax exemption, and that you also have a 10% state income tax rate:

R(te) = 0.05 / (1 – [0.25 + 0.10(1 – 0.25])
R(te) = 0.074

The equivalent taxable yield on the muni paying 5% is now 7.4%.

​​​​​​​Individuals can purchase munis directly through a securities dealer, but the more popular way is through a tax-exempt money market fund. Money market mutual funds typically comprise very large pools of money market securities, perhaps only specific munis, a mix of a variety of munis, or even a combination of munis and other money market instruments. (To learn more, check out Introduction To Money Market Mutual Funds and A Long-Term Mindset Meets Dreaded Capital Gains Tax.)

​​​​Since the income generated by munis is greatly influenced by tax legislation, they are somewhat subject to the taxation philosophy of the government of the day. Prior to the 1980s, munis were extremely popular investments because wealthy individuals paid higher marginal tax rates at the time. The Economic Recovery Tax Act of 1981 lowered the highest marginal tax rate from 70% to 50%, and the Tax Reform Act of 1986 further reduced the top individual rate to 33%.

The reduction of marginal tax rates lessened the popularity of munis, which in turn forced governments to raise muni rates disproportionately higher than that of other taxable instruments. State and municipal governments thereby lost some of the benefits of the inexpensive debt financing they had previously enjoyed, and became less inclined to issue short-term municipal securities to fund various projects or ongoing operations.

Even if the cause and popularity of munis has diminished somewhat since their pre-1980s heyday, they still hold an important place in the portfolios of certain investors. For wealthy investors, munis can lighten the tax burden significantly, especially if the investor benefits from double tax-exemption. Short-term municipal securities can be a very attractive addition to a well-diversified portfolio, especially when the holder of the portfolio falls within the upper echelons of the federal marginal tax rate.