Tax Free Income? Yes Please!

commonwealthofkentuckybridgevigWouldn’t you love tax free income?

Who wouldn’t, right? Municipal bonds are a terrific source of income that is also tax free. Some municipal bonds are taxable as well as subject to the Alternative Minimum Tax, but for this article we’ll be assuming that they are not.

So let’s get to it shall we?

What is a muni or municipal bond? 
A municipal bond is a bond issued by a local government or their agencies. This includes your county or state governments, public school districts, public transportation and airports, and publicly owned utilities. There are lots of other purposes that what I’ve listed here, but it’s to raise funds for the entities improvements or infrastructure repairs. Municipal bonds may be the general revenue obligations of the issuer or secured by specify revenue.

Why would anybody buy a municipal bond?
Tax free interest income…it’s that simple. Munis may provide an exemption from federal taxes and depending on where you live, many state and local taxes too. Municipals are particularly attractive to investors that are in high income tax brackets. Its a way to create investment income without making your tax bill worse. High tax bracket investors simply substitute taxable treasuries and corporate bonds for municipals. Usually the interest rates are lower than that of taxable bonds because of the special tax-exempt status.

What are the types of municipal bonds?
There are basically two types of muni bonds:

  • General obligation bonds: These bonds are secured by the issuer’s ability to tax. Generally these bonds are approved by a public vote.
  • Revenue bonds: These munis are secured by revenue from tolls, charges or rents from the facility the bond proceeds built. Typical examples would be hospitals airports, bridges, water and sewage treatment facilities and subsidized housing.

What are the risks with municipal bonds?
There are several risks that are common with all bonds including municipals. First is credit risk. This is the ability of the issuer to make all payments in full and in a timely manner. Each bond is given a rating from the various ratings agencies. Second, is interest rate risk. Depending on whether interest rates are rising or falling may make your muni fluctuate in value. I discussed this in my article, My Bond Will Do What When Interest Rates Rise?. Municipal bonds historically have had a very low rate of default. This is because they are backed with revenue from projects or tax power from a  government.

If you are in a high tax bracket, want to diversify a portfolio or are looking for income, muni bonds just might be the ticket. They can be a little confusing because some of these as I mentioned are subject to tax. In addition, ratings are different for every agency that rates munis. Consult a good investment advisor before making your purchase.

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