Have you seen anyone that likes overpaying taxes? We haven’t too, but we’ll let you know if one crosses our radar. On the other hand, one thing that’s always on our radar is how to save you more tax money! Especially on a hot summer. One big tax move that makes the summer even better for you is taking tax-free municipal bonds.
Imagine a long-term investment that allows you to earn a higher total return, diversify your portfolio and keep your tax money to yourself. That’s exactly what you get when you invest in tax-free municipal bonds. While investments can be tricky and risky, there’s one way to flip the odds to your side. Read on, and we’ll show you how.
What Are Tax-Free Municipal Bonds?
The term municipal bond is a type of debt security issued by local, county, and state governments. It is an interest-bearing debt obligation that supports general needs or funds a public project. Also known as tax-exempt muni bonds, a municipal bond can also be issued by legal authorities such as a port authority or housing authority.
In addition to helping you create tax-free income, municipal bonds are a win-win. It’s a great way to invest in your community and make more money for yourself. What you get when you invest in municipal bonds is an investment opportunity that allows you to invest in the infrastructure of states and local communities as well as add diversity and tax efficiency to your portfolio.
Most importantly, the income generated from municipal bonds is usually exempt from federal taxes, unlike income generated by corporate bonds, which is fully taxable. Even better, if you live in the state that issued the bond, the state tax and local taxes are also usually exempted.
How Do Tax-Exempt Muni Bonds Work?
In simple terms, a bond is a loan made by an investor to a borrower. While treasury bonds are issued by the US government, corporate bonds are issued by companies, and municipal bonds are issued by state and local governments.
Investors who buy these bonds lend money to a municipality in exchange for regular interest payments for a period of time. The principal is repaid when the loan ends or when the bond matures. The maturity range of tax-exempt muni bonds is usually between one to 30 years.
How do Tax-Free Municipal Bonds Differ?
The exemption from taxes sets municipal bonds apart from other bonds, which is why they are called tax-exempt muni bonds. In addition, municipal bonds differ from other corporate bonds because they retire at maturity.
However, the point where it connects is that, like all other bonds, municipal bonds have interest rate risks. The longer the term of the bond, the higher the risk. If interest rates on the bond rise during the term of your bond, you might be losing out on a better rate.
Types Of Tax-Free Municipal Bonds
General Obligation Bonds: these are bonds issued by government entities and are not backed by revenues from a particular project. They are repaid from tax revenue. Some General Obligation bonds are backed by dedicated property taxes, while others are payable from general funds. They are also considered very low risk and offer the lowest yields.
Revenue Bond: a revenue bond secures interest and principal payments through the issuer or through hotel occupancy, fuel, sales, or other taxes. They are only secured by specified revenue, airport fees, or highway tolls. They are considered riskier than general obligation bonds because of the limit on funds used to repay bondholders. Unlike general obligation bonds, revenue bonds don’t rely on taxes to pay back bonds and offer a higher yield.
Commercial Paper: commercial papers are short-term debt issued by the government to meet cash budget shortfalls, management needs, and more. They are also backed by a bank letter of credit and generally carry maturities of less than nine months. Because of the short maturities of these bonds, the yields offered are generally low.
Private Activity Bonds: they are used to fund private pursuits that are classified under federal law as tax-exempt status. However, they are considered riskier than general obligation and revenue bonds and, as a result, offer higher yields and may not be tax-exempt.
How To Buy Tax-Free Municipal Bonds
Generally, you can buy and sell municipal bonds through a broker. There are three major ways you can invest in tax-exempt muni bonds:
- Individual bond: it can be bought through a broker, but it requires you to do your own research and decide whether to buy new bonds or issues through the secondary market where you can buy municipal bonds already issued to other investors. However, you’ll need to investigate credit risk since your municipal portfolio might not be as diversified as a mutual fund or ETF.
- Municipal bonds mutual funds: you can invest in a wide range of muni bonds that offer you the diversity you can’t get on your own while still giving you a federal tax advantage and, in some cases, state or local tax breaks.
- Mutual bond ETFs: they are a great way to invest in diverse municipal bonds. Like mutual funds, the income from this bond is tax exempt from federal taxes, and some interest earned could also be exempt at state and local levels depending on your location.
Are Tax-Free Municipal Bonds Safe Investments?
Municipal bonds are generally considered safe investments because they include lower default rates and higher credit ratings compared to corporate bonds. In addition, a lot of munis are backed by insurance that guarantees payment in case of a default.
This, however, does not make tax-free municipal bonds immune from default. It’s important to understand credit ratings so you can evaluate the risk and make an informed choice.
In addition, munis carry interest rate risk such that when interest rates fall, prices for the existing bonds paying higher rates will also rise. As a result, when interest rates rise, prices of the existing bonds paying lower rates will also reduce. The good side of this is that if you hold tax-free muni bonds to maturity, price risk won’t be a factor. You can only experience the highs and lows if you’re buying and selling the muni bonds.
Municipal Bonds Tax Traps
In some cases, tax-free municipal bonds may not be exempt from federal taxes if they are used to fund an activity unqualified for tax-exempt status based on the IRS rules, such as paying pension fund liability.
It is also important to watch out for the type of account you use to purchase your tax-free municipal bond. While a traditional IRA or 401(K) retirement account already grows tax-free, most investors prefer holding tax-free munis in a taxable brokerage account to make the most of municipal bonds’ tax-free status.
In addition, if you buy and sell municipal bonds, you could also be liable to capital tax gains on profits from the sales or for bonds bought at a discount price. Also, if you’re subject to the alternative minimum tax, you may have to pay some taxes on municipal bond interests.
While municipal bonds have tax exemptions, they are not entirely free. There may be state income taxes on the interest. If you receive social security, your municipal bond interest will count towards your adjusted gross income, which could increase the taxable amount of your social security income.
Tax-free municipal bonds are a great way to create tax-free wealth. They are relatively safe and also help you diversify your portfolio. While the yields may not be as profitable as taxable bonds, they are a good alternative if you’re looking for a reliable stream of income, especially in your retirement years.
However, to make the most of your muni bonds, you have to do your due diligence by choosing the best municipal bonds or working with experts who can make the right choices for you.
If you’re looking to reduce your taxable income with muni bonds, there are also other valuable tax strategies to explore to help you maximize the benefits. Whenever you’re ready for the complete tax strategy tour, don’t hesitate to reach out to us at Tax Goddess so you can get the full legal benefits.