The Tax-Free Income Potential of Municipal Bonds
Posted by Richard on April 17, 2013
Municipal bonds (also known as “munis”) are fixed-income investments that can provide higher after-tax returns than similar taxable corporate or government issues.1 In general, the interest paid on municipal issues is exempt from federal taxes and may also be exempt from state and local taxes if they are purchased by residents of the issuing municipality.
Nobody likes to pay taxes. That’s why investors naturally are interested in earning tax-free income. Municipal bond issues are a very popular way to earn tax-free income and, if income is reinvested, achieve tax-free compounding of returns.
Municipal Bonds Defined
A municipal bond is an interest-bearing debt obligation issued by a state or local municipality, which may support general government needs or fund a public works project. A municipal bond can also be issued by legal entities such as a housing authority or a port authority. A variety of projects, such as new roads, stadiums, bridges, or hospitals are usually financed through the issuance of municipal bonds. In addition to providing tax-exempt earnings, municipals can be an excellent way to invest in the growth and development of your community.
Municipal bonds are different from corporate bonds in several ways.
• The income they generate is usually exempt from federal taxes, whereas the income generated by corporate bonds is fully taxable. In addition, if the investor lives in the state that issued the bond, the state tax is usually exempted.
• Corporate bonds are usually issued with “term” maturities, but many municipal bonds are issued with “serial” maturities. This means that the bond is issued with several maturity dates. A portion of the principal matures with each maturity date until the entire principal has been paid off. The interest rate of a serial issue can also be different with each redemption date.
• Corporate bonds are usually issued in $1,000 amounts, but municipal bonds are usually offered in principal amounts of $5,000.
• Municipal bonds are traded only on the over-the-counter market, whereas some corporate bonds are listed on exchanges.
Types of Municipal Bonds
• General Obligation Bonds: Backed by the full faith and credit of the issuing government and its taxing power. They are generally considered lower risk and thus offer the lowest yields.
• Revenue Bonds: Secured only by a specified revenue source such as highway tolls or airport fees. They are considered somewhat riskier than general obligation bonds and thus usually offer higher yields.
• Commercial Paper: Short-term debt issued by governments to meet cash-management needs, budget shortfalls, and the like. Typically they are backed by a bank letter of credit and carry maturities of less than nine months. The yields offered are generally low due to their short maturities.
• Private Activity Bonds: Used to fund private pursuits that qualify under federal law as having a tax-exempt status. They are considered riskier than revenue and general obligation bonds and thus offer higher yields. They may not be tax exempt.
Understanding Taxable-Equivalent Yields
Municipal bonds usually have a yield several percentage points below the yield on corporate bonds of comparable maturity. This means that a municipal bond can provide the same after-tax yield as a taxable bond paying a higher interest rate. If you are in a high tax bracket, the benefits of using municipal bonds in the bond portion of your portfolio are impressive. For example, if your income tax rate is 28%, a municipal bond paying 6% interest is actually a better investment than a taxable bond paying interest at 8.3%. You can easily calculate the comparable yield on a taxable investment, known as the taxable-equivalent yield.
1Municipal bonds are subject to availability and change in price. They are also subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax free, but other state and local taxes may apply.
This communication is not intended to be tax advice and should not be treated as such. Each individual’s tax situation is different. You should contact your tax professional to discuss your personal situation.
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