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Tax-Free Bonds in Focus

Interest rates have moved up, and with higher taxes a reality for many investors in 2014 and beyond, investments that are tax-free have particular appeal.  Despite some recent high profile defaults, and problems in troubled municipalities like Detroit, Municipal bonds have an exemplary track record of safety, and bonds issued within the state of South Carolina offer returns that are free from both federal and state taxes. Let’s look at some basic background on these investments, as well as a few tips on getting started.

The State of South Carolina, as well as our cities, counties, and improvement and utility districts, all issue bonds to finance operations, capital expenditures, and development. These bonds have a stated interest rate and a promise of repayment at a specific time in the future, known as the maturity date. The safety of these bonds, both investment income and principal, is determined by the source of the funds designated for repayment. The two major categories of Municipal bonds are General Obligation, or G.O. bonds, and Revenue bonds. General Obligation bonds are backed by the taxing power of the issuer, which could mean income taxes, in the case of State of South Carolina, or property taxes, for bonds issued by a county. Revenue bonds, on the other hand, are backed by revenue from the particular project for which the bonds are issued. For example, bonds issued to pay for the Cross-Island Expressway would be backed and repaid by toll revenue from drivers who use the expressway.

Calculating the taxable equivalent yield

In order to determine if a tax free bond makes sense for you, you will need to compare it with a taxable investment. Let’s take as an example a Aa1/AA+ rated General Obligation unlimited tax revenue bond issued by Beaufort County, maturing in 12 years, paying interest twice a year, which has a yield of 3.7%.  You are in a combined federal and state tax bracket of 30%. First, subtract your tax rate expressed as a percentage (.30) from 1.  So, 1.00-.30=.70.  Then, divide the yield on the bond (3.7%) by .70 to determine the taxable equivalent yield, which is 5.28%. You would have to get a 5.28% rate of return on a taxable investment to equal the after-tax return on your 3.7% tax-free bond.

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TAGGED: Investments
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