Municipal Bond Forum
On “Hidden Gems in the Muni Market”
Q
I enjoyed your article about premium muni bonds generally having a higher effective yield, but I’d like to point out what I believe is an equally offsetting downside. As we know, the interest payments by the premium bond are higher compared to the equivalent par bond (i.e. compensation for having paid an upfront premium). Therefore, the state income tax on these bonds (from states other than one’s home state; in my case, Idaho) will be higher because there is no mechanism that I know of for deducting the premium paid for the bonds. So, without finding a legitimate way to deduct the premium for state income tax purposes, I estimate that my additional taxes to Idaho on an out-of-state muni bond purchased with a 6% premium eats up most of the 0.5% higher yield you cite in your article (i.e. 7.8% Idaho income tax x 6% premium = 0.47%).
A
James A. Klotz responds:
Yes, the Idaho state tax will reduce the net yield on your out-of-state bonds, but the impact will not be significantly different on a premium bond than on a bond purchased at 100.00 (par). Our article compared a 5 1/2% premium bond with a 4 1/2% par bond. Assuming you own $100,000 of each, the premium bond would produce $5,500 per year, while the par bond throws off $4,500 annually. The Idaho state tax of 7.8% would reduce the annual income by $429 and $351 respectively. This $78 difference in state tax has a negligible effect on the premium vs. par bond yield comparison. Keep in mind that the Idaho tax you pay is deductible for federal income tax purposes.
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