Evaluating Tax Advantages in Municipal Securities

Basics

Investing in Treasury bills or money market mutual funds is renowned for the liquidity and security they provide. However, a distinctive group of money market instruments, called 'munis' or short-term municipal securities, offer an additional advantage that can significantly benefit individuals in the high federal tax bracket: substantial federal tax savings.

Defining Municipal Securities

Municipal securities represent interest-bearing debts issued by state and municipal governments to support operational expenses, extend financial support to select tax-exempt entities like educational institutions and nonprofit hospitals, and occasionally offer financial backing to businesses and individuals. The tax-exempt nature of these securities not only spares investors from tax on interest income but also facilitates government issuers in securing favorable borrowing rates.

While municipal securities are typically grouped as short-term investments, they technically qualify as such only when their maturity does not exceed three years. Among short-term munis, several note categories exist, including bond anticipation notes, tax anticipation notes, and revenue anticipation notes. The common thread in these notes is their anticipatory nature, signifying their role in providing immediate, short-term funds to bridge financial gaps until government proceeds from bond issuances, taxes, or revenue-generating projects become available.

In the realm of longer-term municipal securities, tax-exempt commercial paper, and variable-rate demand obligations enable state and municipal governments to finance extensive, enduring projects at short-term interest rates. Three additional long-term muni types include swaps, municipal preferred stock, and floaters/inverse floaters. These instruments empower issuers to secure long-term fixed-rate financing while offering investors access to floating-rate short-term debt.

Assessing Tax Impact on Muni Investments

Investors opt for munis primarily when facing a substantial federal tax burden, seeking tax relief. Munis typically yield less than taxable securities, necessitating an evaluation of whether tax savings compensate for the lower yield.

Muni yields are commonly expressed in terms of the equivalent taxable interest rate, which would yield the same after-tax interest. The formula for calculating the taxable equivalent interest rate for munis is as follows:

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, if your marginal tax rate (t) is 25%, and you are considering a tax-exempt muni with a 5% yield, here's how you calculate the muni's after-tax interest rate:

R(te) = 0.05 / (1 – 0.25)

R(te) = 0.067

To outperform the muni, a taxable security must offer a yield exceeding 6.67%.

Enhanced Tax-Exemption Advantages

Beyond the federal income tax exemption, munis can also provide state income tax exemption when an investor acquires securities issued by their home state or local municipalities. For investors benefiting from this dual tax exemption, a modified version of the previous formula is applied to compute 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

Suppose all variables remain consistent with the previous example, except that the muni offers a double tax exemption, and the investor faces a 10% state income tax rate:

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

R(te) = 0.074

The muni, with a 5% yield, now yields an equivalent taxable rate of 7.4%.

Muni Investment Options

Investing in munis is possible through direct transactions with a securities dealer. However, the more common approach involves investing via a tax-exempt money market fund. These funds often encompass substantial collections of money market securities, consisting of specific munis, a diverse muni portfolio, or a blend of munis and other money market instruments.

Challenges in Muni Investments

Muni income is notably influenced by evolving tax legislation, making it sensitive to the government's tax policy. Munis were exceptionally favored investments before the 1980s, especially when high-income individuals faced substantial marginal tax rates. However, the Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986 substantially reduced these top tax rates, diminishing the appeal of munis.

Lower marginal tax rates resulted in munis losing popularity, leading governments to increase muni rates disproportionately compared to other taxable instruments. This shift negatively impacted state and municipal governments, causing a reduction in the advantages of low-cost debt financing. As a consequence, these governments became less inclined to issue short-term municipal securities for their projects and ongoing operations.

Conclusion

While the prominence of munis has waned since its pre-1980s peak, they remain a crucial asset for specific investors. Wealthy individuals, particularly those enjoying double tax exemption, can substantially reduce their tax liability with munis. Short-term municipal securities can be a valuable component of a diversified portfolio, particularly for high-income investors.