You’ve probably heard of the phrase “tax-free municipal bonds” and wondered what they are, and whether they have a place in your financial plans.
If you are tax-sensitive (i.e. looking to keep taxes low), and seeking to preserve assets while earning competitive interest—in short, if you’re looking to keep as much of your retirement nest as possible—you probably want to consider municipal bonds, or "munis" for short.
What they are
Munis are IOU's issued by city, county, and state governments in order to raise money for community projects like highways, public schools, hospitals and stadiums. They are potentially a great way to support your local community AND make some extra money with relatively low risk.
When you buy a muni, you are loaning money to the issuer in exchange for a set number of interest payments over a certain amount of time (one month to 30 years). At the end of that period, the bond “matures” and the full amount of your original investment is returned to you, on top of the interest you’ve accrued—again, tax-free.
It sounds like a good deal—and munis can be. But in the last few years, state and local governments are cash-strapped, so yields are lower and it can be harder to find top-rated bonds.
How they work
There are two types of municipal bonds: general obligation (GO) and revenue. GOs are backed by tax dollars. Revenue munis are backed by cash generated from usage (highway tolls) or utility bill-payments (water, gas, electric).
Munis are primarily purchased by investors in higher tax brackets because their interest is free from federal taxes (AND state and local taxes if investors live in the same state where they are issued). If you are an average investor interested in fixed income investments, tax-free munis may not always be a better choice than fully-taxable corporate bonds, which typically pay higher interest rates.
You can calculate which type of bond will provide you the greatest after-tax return using the taxable equivalent yield formula: (muni yield) / (1 - tax bracket). If your math skills are rusty, you can use BankRate.com’s calculator.
Know the risks
While most munis are tax-free, they are not risk-free, which is why they typically pay more than a savings account or CD. The biggest risk associated with munis is credit risk (when the issuer is unable to make its scheduled interest payments and/or repay your investment at maturity). To minimize credit risk, stick with highly-rated munis.
Many munis—including some that are lower-rated and higher yielding—also come with insurance guaranteeing repayment, but that doesn't necessarily mean that they are safer. (It depends on how stable those insurance companies are.)
Individual bonds must be purchased through a broker and typically require a minimum investment of $5,000. Because they are difficult to adequately research, you will probably want to consult a financial professional who specializes in munis or consider a no-load muni bond mutual fund or exchange-traded fund (ETF), which can offer a cheaper and easier way to invest in a broad basket of munis.
However, keep in mind that muni funds pay unpredictable income that may not be state and local income tax-free, and that a corporate bond fund may still give you a better return depending on your tax bracket.
Muni bonds may be an attractive option for you if you have a specific-term savings goal or want regular income and are looking for better rates than the bank offers. They can also help protect a portion of your investment portfolio and save you money if you are in a higher tax bracket. These bonds can pay off, as long as you do your research and plug them into your plan in a way that makes sense.