Understanding Tax-Free Bonds

It’s not what you earn, it’s what you keep. That adage applies to investment income as well as wages. Investors in tax-free bonds don’t have to worry about the federal tax implications of certain bond income, as it is tax free. While many federally tax-free bonds are subject to state and local taxes, there are tax-free bonds that are also free from state tax. Tax-free bonds are also known as tax-exempt bonds.

Pros and cons of tax free bonds.

Federally Tax-Free Bonds

Issued by states, counties, cities and other governmental authorities, municipal bonds are the primary methods by which these entities raise capital for public project financing. Income from these bonds is from federal taxation. In fact, these are the only securities free from federal income tax. Municipal bonds are considered a safe investment. While municipal defaults are a possibility, such events are rare.

The most common types of municipal bonds are:

  • General obligation bonds: These bonds are not secured by assets. Instead, backing is via the full faith and credit of the state, city, or county issuing the bond. These issuers have the ability to tax residents so that bondholders are paid.
  • Revenue bonds: These bonds are backed by the revenues of a specific project and not by the government’s power to tax. Examples include revenue bonds for toll roads. Tolls from motorists are used to pay off such bonds.

You can purchase state-specific bonds that are free from federal, state and local tax. You must live in the state issuing these bonds in order to take advantage of state and local tax exemptions.

Keep reading for more info on tax-free bonds.

Pros and Cons of Municipal Bonds

The tax advantages of municipal bonds constitute the primary appeal for investors. Because they are fixed-income investments, bond buyers know they will receive steady, semi-annual income payments for the bond’s life.

On the con side, there’s  a call risk with municipal bonds. That means the issuer can repay the bond prior to its maturity date. When that happens, as when interest rates decline, the investor must reinvest their money at less attractive rates.

Inflation poses another risk factor. Along with purchase power reduction, inflation can lead to higher interest rates. In turn, this reduces the bond’s market value.

Bonds may suffer from a liquidity risk. Because so many bonds are purchased by investors for holding rather than active trading,  when they do want to buy or sell a bond they may not obtain the desired price. In fact, they may discover the same bond has various quotes.

State and Local Tax-Free Bonds

Income from bonds issued by the federal government is not free from federal taxation. However, such bonds are usually exempt from state and local taxes. This includes income from Treasury bonds.

Short, Intermediate and Long-term Tax-Free Bonds

Tax-free bonds are available with short, intermediate and long-term maturities. A bond’s interest rate is determined at its origination.

  • Short-term tax-free bonds: Short-term bonds have a maturity date of three years or less. Risk is lower, but so is yield.
  • Intermediate-term tax-free bonds: These maturity dates of these bonds is between two and 10 years. Because they fall into the middle of bond categories, their risk and return rate is also in that range.
  • Long-term tax-free bonds: Long-term bonds maturity dates range from 10 to 25 years. Higher yields accompany greater risk. Because the bond takes so long to mature, inflation and interest rates are more likely to affect it.

How to Buy Them

Purchase tax-free bonds from an online or full-service brokerage or bank. Such purchases come with commissions. Before buying individual bonds, determine how these securities fit into your overall portfolio and tax strategies. When buying individual bonds, keep in mind that you will not receive the principal back until the bond’s maturity.

Many investors create a “ladder’ of municipal bonds to address the need for regular income. This portfolio involves a maturity date range. As bonds mature or are sold, the principal is regularly reinvested. The investor receives a steady income stream with less exposure to interest rate risk.

For most investors, the simplest way to purchase tax-free bonds is via a tax-free bond fund or ETF. Expect to pay sales charges and other fees. In either case, you own shares of the fund, rather than owning bonds outright. While funds offer more bond diversification, fund managers may sell bonds to offset falling market value when interest rates rise. That means the fund’s value may fluctuate.

One caveat: When purchasing shares of a bond fund or ETF holding any federal government bonds, it is your responsibility to determine the amount of federal bond income received. This information is not included in the tax forms provided by the investment company.

Taxable vs. Tax-Free Bonds

Not all municipal bonds are tax-free. State and local governments may issue taxable municipal bonds that do not meet the IRS criteria for public use or public purposes. Examples include bonds issued to finance sports facilities or boost public pension funding. Taxable municipal bonds tend to offer higher yields than tax-free bonds.

It is possible that taxable municipal bonds are exempt from state and local taxes for residents of that state. Always read the related documents pertaining to the bond or consult a financial advisor to determine a bond’s tax status before investing.

Tax-Free Bonds Ratings

No two municipal bonds are exactly alike. If going the individual tax-free bonds route, perform your due diligence by examining the bond’s rating. Three major agencies rate municipal bonds. These are Moody’s Investors Service, S&P Global and Fitch Ratings. The first two agencies rate over 80 percent of municipal bonds. For all three services, the best bonds are rated Triple-A. High and upper medium grade bonds are A rated, although the different agencies use different investment grading categories. Medium grade bonds have B ratings, although again the agencies use different gradings for essentially the same rating. For instance, Moody’s highest B rating is Baa, while S&P and Fitch use BBB+.

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