The primary advantages of attracting an investor to Treasury bills or 澳洲幸运5官方开奖结果体彩网:money market mutual funds are their liquidity and safety. But there is another significant beneꦦfit offered by particular money market instruments known as 'munis' or short-term municipal securities: federal tax savings, which are particularly beneficial to th﷽ose who fall within a high federal tax bracket.

Munis Defined

Municipal securiജties 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 澳洲幸运5官方开奖结果体彩网:bond anticipation notes, 澳洲幸运5官方开奖结果体彩网:tax anticipation notes, and 澳洲幸运5官方开奖结果体彩网:revenue anticipation notes. The keyword 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 澳洲幸运5官方开奖结果体彩网:The Basics Of Municipal Bonds.)

Within the universe of longer-term munis, there is tax-exempt 澳洲幸运5官方开奖结果体彩网: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/澳洲幸运5官方开奖结果体彩网:inverse floaters, all of which enable issuers to borrow at long-term fixed rates while providing investors with floating-rate, sh♔ort-ꦇterm debt.

Individual Tax Rates

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

The yields on munis are therefore of🐼ten articulated in terms of the taxable interest rate that would be required to provide the same after-tax interest rate. The formula for𝓰 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 澳洲幸运5官方开奖结果体彩网: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 fav⛦orable than ❀the muni, taxable security would have to offer you a yield higher than 6.67%.

Additional Tax-Exemption Benefits

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 their home state or by municipalities located in their home state. If the investor receives this double tax exemptio🎐n, they use 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 everyth𒉰ing is still the sam🧔e 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%ꦜ.

Investing in Munis

​​​​​​​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.)

Downfalls of Munis

​​​​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 澳洲幸运5官方开奖结果体彩网:Tax Reform Act of 1986 further reduced the top individual rate to 33%.

The reduction of marginal tax rates lessened the populꦚarity 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.

The Bottom Line

Even if the cause and popularity of munis has diminisheℱd 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 thඣe upper echelons of the federal marginal tax rate.