The Municipal bond will always display a lower return than a comparable taxable bond. To compare them, you have to determine the tax equivalent yield.
Step 1: Find the Municipal bond's current return.
Step 2: Determine the taxable bond equivalent return for your tax bracket:
http://www.bankrate.com/calculators/retirement/tax-equivalent-yield-calculator-tool.aspxStep 3: Subtract your deductions (401k, IRA ...etc)
Step 4: Compare this to the equivalent term taxable bond.
Example:
iShares National AMT-Free Muni Bond - 0.25% ER (yearly fee)
Step 1: Find the Municipal bond's current return: 1.64%
Step 2: Determine the taxable bond equivalent return for your tax bracket:
10% tax bracket: 1.822%
15% tax bracket: 1.929%
25% tax bracket: 2.187%
28% tax bracket: 2.278%
33% tax bracket: 2.448%
35% tax bracket: 2.523%
39.6% tax bracket: 2.715%
Step 3: Maxing out 2 401k's = $36,000.
A combined married salary of $266,000 - $36,000 = $230,000 = 28% tax bracket.
This gives a Municipal bond taxable equivalent return of 2.278%
Step 4: Compare this to the equivalent term taxable bond:
Intermediate-Term Bond Index Admiral Shares - 0.10% ER (yearly fee) -
Return: 2.43%In this example, the couple is better off with the taxable bond. If the couple in this example have a combined salary of $447,000, putting them in the 33% tax bracket, the Municipal bond will give them a 2.448% return, while the taxable bond gives them 2.43%. A slight edge, but don't count on it to be consistent, as they are close enough to fluctuate throughout the year. It seems the Municipal bond wouldn't be consistently better until they get to the 35% tax bracket.
I purposely omitted calculating the expected bond returns for the year, and adding that to your income, as yields in the 2% range don't really add much to the discussion. Even if you had $400,000 invested in Municipal bonds, that's only adding $8,000 a year to your income.
Hope this helps!
