Tax Exempt Municipal Bonds

Investing in municipal bonds has become very popular over the past decades. Municipal bonds are those that are issued by local and state governments and may include states, counties, cities, schools and municipal authorities. The interest payments on municipal bonds are tax exempt which means that you do not have to pay federal income tax on your returns. However, you should note that they are normally subject to local and state taxes. Investing in tax exempt municipal bonds can provide you with great benefits although it is important that you fully understand how this investment opportunity works before making your initial investment.

Understand that the higher the tax bracket on municipal bonds, the higher the yield that you will be returned. If you consider purchasing a 6 percent bond at par and this bond is in a 28 percent tax bracket for instance then the tax free yield on that bond will be higher than your initial 6 percent. The formula that is used is that the municipal state rate is divided by 100 with the tax bracket subtracted.  A breakdown of the formula would resemble this: 6 percent divided by 72 (which is 100 minus 28) would equal 8.33 percent. This simply means that in order for you to receive a better return than a 6 percent coupon bond you will need an equal or better taxable investment than 8.33 percent. If you invest in a lower tax bracket then you will show a lower tax free yield.

There are two basic types of municipal bonds or in other words, two ways that a municipality can back the bond or guarantee it. The first way of backing a municipal bond is through a taxing power of that municipality. These are normally referred to as General Obligation Bonds. The other way of backing is known as a Revenue Bond. A Revenue Bond uses specific sources of revenue in order to guarantee the bond.

General Obligation Bonds are the most commonly found type and typically offer better rates. A state that is raising money and then backing bond issues with higher sales or income taxes would fall under General Obligation Bonds. A school district that may be raising money through broker dealers and securing bonds with property tax or school revenue would also be a General Obligation Bond. Taxes are considered to be the most secure source for money today and far into the future so most investors prefer to purchase bonds that are secured by taxes over those that are secured by revenue.

Revenue Bonds rely on revenue of specific facilities or production abilities or through other means by the issuer in order for security. There are many different types of issuers that may include transportation such as airports and toll booths, health care including hospitals, utility or electric/water companies and industrial issuers.

An investor that purchases municipal bonds that are issued within the state in which they live are exempt from paying federal, local and state taxes. This means that if you want to enjoy tax free municipal bonds you should consider buying bonds from the state in which you live. Individual investors typically prefer to purchase from within their own states while larger corporations may purchase municipal bonds from all over the nation. Municipal bonds are simply a way of supporting your local community while building up your investment portfolio.

There are a few things that you should consider prior to purchasing tax exempt municipal bonds. You should first calculate to determine whether a tax exempt bond is a better option for your needs than a traditional bond. This can be done by converting the rate of a traditional bond to that of the after tax rate of a tax exempt municipal bond. Whichever of the two offers the highest interest rate is the best option for investment. Remember also that in order to purchase a tax exempt municipal bond you will need to purchase from within your specific state. You should also note that defaults do happen on these bonds although they are very rare. Take your time and speak with a financial consultant if needed to determine if a tax free municipal bond is the right choice for your investment portfolio.

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