The quoted yields for munis tend to be lower than those of corporate or government bonds because of the tax advantages. Remember, interest on corporate bonds is fully taxable and government bonds are taxable at the federal level even though they are tax-exempt at the state and local levels.
Munis, however, are tax-exempt at the federal level and can be exempt at the state and local levels. If your client is in a high tax bracket, the taxable equivalent yield on municipal securities can be much higher than on fully taxable securities. There are a couple of exceptions to this rule:
Alternative Minimum Tax (AMT)
AMT was designed in the late 1960s to confront the perception that the rich do not pay taxes. If the IRS determines your client must pay the AMT, the tax advantage he expected when he invested in munis evaporates, along with many other tax shields he was relying on.
However, there is some good news here: the only munis that are subject to the AMT are those that fund "private activity". Which ones are they? Who knows! The vast majority of munis are not subject to the AMT, but it is still a good idea to look at the cover of the issue's indenture, or official statement, before selling its supposedly tax-exempt bonds to your client.
If your client is buying debt from the state he or she happens to live in, or of any municipal entity within that state, then your client is entitled to tax exemption at the state and local levels. This is sometimes called triple-tax-exempt or triple-tax-free.
On the other hand, if your client lives elsewhere it is your responsibility as the registered representative to explain that interest income from the bond may be taxed at the state and local levels even though it is shielded from federal income taxes.
Remember, federal income tax is much greater than state and local income taxes - in fact, many localities and several states have no income tax at all. Therefore, munis, which are federally exempt, make for a much stronger tax shield than government bonds.
Munis are thus the preferred fixed-income investment of the well compensated.
The article Weighing the Tax Benefits of Municipal Securities contains further information on determining whether the tax exemption offered by munis is beneficial.
Let's take a closer look into determining the suitability of a particular municipal bond in your client's portfolio.
Determining Muni Suitability For Clients
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