Are you in a high federal income tax bracket? Does your state collect a high income tax? Then you may want to consider investing in municipal bonds. They are federal income tax free. Plus, you can purchase ones from your home state that are state-tax free.
Municipal bonds are bonds that are issued by a state government/municipality. They are debt obligations. You loan the state/city money in exchange for interest payments. The bonds are issued for a set amount of time. At maturity, you receive your principal back. Interest payments are received at set intervals (usually semiannually) for the life of the bond.
The main advantage to a municipal bond is its favored tax treatment. The bond is a very good way for anyone in a high-tax bracket to invest. No federal tax on the bonds helps an investor accumulate more in their portfolio. It is wise to purchase bonds from the state of residence to avoid state taxes as well.
Municipal bonds do carry risks. Cities can default on their bonds. This happens rarely. However, investing in a bond fund will diversify your holdings and diminish default risk.
Another problem with municipals is that some are subject to the Alternative Minimum Tax (AMT). The AMT is calculated on certain income that may not be subject to standard federal taxes. One way to avoid this tax is to avoid purchasing private activity bonds. This term refers to bonds issued by a state for a private business such as a hospital.
Municipal bond funds are a convenient way to invest in municipals. They offer diversification and cost efficiency. One problem is that they will fluctuate some since they move up and down with the municipal bond market. A yearly fee will be charged by the fund company for managing the fund.
Individual bonds can be purchased through a brokerage firm. You will be charged a fee/commission to purchase them. However, no more fees will be incurred if they are held to maturity. The disadvantage to this strategy is that you will need to purchase many bonds to have good diversification.
Municipal bonds will have a lower interest rate than corporate or U.S. Treasury bonds. However, they may yield more for your situation due to your tax bracket. Many online bond calculators can quickly calculate which type of bond will give you the most interest. It is worth taking a few minutes to do the calculation as taxes can take a big bite out of returns.
The bonds are often backed by insurance and given ratings. These ratings are a guide to the bonds ability to return principal and make interest payments. Rating agencies such as Standard & Poor's and Moody's are a good place to check before investing.
Municipal bonds can make a good investment. These bonds have long been considered a fairly safe investment. You may wish to add them to your portfolio after considering your tax status.