The Benefits Of Tax Free Bonds

Tax free bonds can be a great investment that lowers your tax obligations while still maintaining a fixed passive income.  These bonds generally come in the form of municipal bonds or Treasury bonds.  The tax advantage comes into play on the interest earned.  Which can be exempt from your state, local, or federal income tax.  Making tax free bonds a favorite investment among retirees and individuals in higher tax brackets.

Municipal Bonds

Municipal bonds are bonds issued by states, cities, and counties for funds to build public projects.  That new school, hospital or highway being built in your area is probably funded through a municipal bond.  The local government gets the funding up front which usually gets the project started and finished sooner.

The interest income from tax free municipal bonds is exempt from federal income tax.  Depending on the state you live in, it may also be exempt from state and local taxes, too.  Generally, the higher your tax bracket the more benefit you’ll get from a tax free municipal bond.  One thing to note, you’ll get no added tax benefit by holding these bonds in an IRA or retirement plan.  Since the IRA or retirement plan already offers tax exempt status, you’re better off looking into taxable municipal or corporate bonds.

Like any investment, there are risks involved with tax free municipal bonds.  The primary one being that the government defaults and won’t be able to pay the interest and/or principal.  Inflation risk is always a possibility.  Where inflation may lower the purchasing power of the interest income over time.  Lastly, if you plan on selling the bonds before maturity, there is interest rate risk involved.  Along with the potential capital gains tax if you profit from the sale of the bonds.

U.S. Treasury Bonds

U.S. Treasury bonds are bonds backed by the full faith and credit of the U.S. government.  These bonds are only tax free from state and local income taxes.  All interest income is subject to federal income tax.  If you live in a state with no income tax, you’ll miss out on any tax benefits.  Even without a tax benefit, these bonds offer the best safety for your money.

Being the safest investment for money, doesn’t eliminate all the risks.  U.S. Treasury bonds are still subject to the same risks as municipal bonds.  There are TIPS bonds that have a built in inflation protection.  But interest rate risk and default risk, though small, still exists.

Tax Free Bond Funds

Not interested in owning individual tax free bonds?  There are many tax free bond funds available.  These funds are mutual funds or ETFs that offer the advantage of diversification while still providing tax free interest income.  Because these funds own many bonds, you’ll miss out on a fixed interest rate and maturity date.  There is also a chance of capital gains tax if you sell your shares.

Each tax free bond fund will have different investment goals.  For instance, one bond fund may only invest in municipal bonds from one state.  Another may only invest in riskier higher interest rate municipal bonds.  Make sure the investment goals of the fund line up with your own goals before committing any money.

If you’re looking for another reason to lower your taxes or just add some additional passive income, take advantage of the benefits of tax free bonds.

If you enjoyed this article, get email updates (it's free).


    • J.P. says

      I remember seeing a CNBC interview after she made that call. Munis dropped in value. If you bought then, you would have gotten in on one of the greatest trades of the year. Of course, just yesterday Jefferson County, Alabama filed for municipal bankruptcy. I’m sure Whitney will be back to say how she was early on her prediction and it will all happen in 2012. I see her point but not every state has budget issues like California or Illinois.

      • says

        Jefferson County was $3.2Billion! Not a very small county default…second largest after somewhere in Cali last year. VERY scary. If there is a bankruptcy and it goes smoothly I believe it will be a domino effect

        • Narayana Swamy says

          The Jefferson county bankruptcy was no surprise – it has been expected for a few years now. sot it won’t roil any markets. no domino effect should be there. The Penn state court canceled the chapt 7 bankruptcy filed by the city of Harrisburg – it goes under state receivership and control now. As I have told in my blog before, bankruptcies are not real viable options for cities and counties to get their finances in order.

  1. says

    I’m jealous of this perk you guys have down there in the states. There is no tax incentive for us to hold any kind of government bonds up in Canada unless you put them in your retirement account (similar to a 401K). I think this is a great idea and gives a nice incentive to provide a publicly owned debt instead of asking China to buy it.

  2. says

    I have some TIPS with Vanguard but will be looking at munis for retirement. That is a few years down the road..They are a great source of tax free income for those on a fixed income however I still have a longer investing horizon so equities makes more sense for me now.

  3. Neo says

    I own two Muni bond funds that have performed well throughout 2011. One is a national, high-yield bond fund and the other is NY state focused, which I purchased since I live in NYC. Generally speaking munis are relatively expensive right now, however, the tax-free yields are still attractive at ~3%, especially since the funds are up about 8% this year. I do not see myself exiting these positions based on short-term volatility or government budget issues.

Leave a Reply

Your email address will not be published. Required fields are marked *