How Do Tax Free Municipal Bonds Work?

When you ask, "How do tax free municipal bonds work?" you'll discover the safest security investment short of U.S. Treasury notes. By buying tax free municipal bonds, you're loaning your hard-earned cash to the state or local government that issues the municipal bonds, so your investment is backed by the municipality's tax revenue.

Additionally, about one-third of tax free municipal bonds are insured, so even if the backer of the municipal bond goes under, you'll still receive your interest payments on time, as well as the municipal bond's face value upon maturity. There's a price for this safety, though. Return rates on tax free municipal bonds are much less than you'd enjoy from a good stock pick.

Tax free municipal bonds work for their issuers by providing a cozy tax shelter for investors in high income brackets.
Every cent of your interest payments are exempt from federal and state taxes. Now for the catch. Your capital gains from investing in tax free municipal bonds are still subject to taxation. That "tax free" label sounds great, but it's not telling you the whole story.

Tax free municipal bonds work by offering bonds at a lower price than their par value, the denomination that's paid out when the bonds mature. The municipal bond's maturity date tells you when you'll be able to cash it in, while the coupon rate indicates the interest that's paid out annually. You'll typically receive your tax free municipal bond's interest payment every six months.

Tax free municipal bonds come in two flavors: general obligation (GO) bonds and revenue bonds. GO bonds are the safer of the two, backed by the municipality's full financial resources. Revenue bonds rely on revenue that's generated from a particular project, such as a power plant or a toll road, for the funds to pay out the interest and principal. They're still very safe investments, but if the project that they're financing tanks, you can end up holding a worthless bond.

Default is just one risk of investing in tax free municipal bonds. Tax free municipal bonds work to the issuing municipality's advantage by giving them the option to call the bonds at any time. When a call is issued, the municipality repays your principal early, cutting off your income from the interest payments. Calls are most often issued when interest rates drop, allowing municipalities to re-issue their bonds at lower interest rates. Defaults and calls aside, your tax free municipal bonds' greatest enemy is inflation. Municipal bonds don't offer a high yield and if inflation outpaces their interest rate, your investment's real dollar value becomes pretty meager.

Be sure to check the tax free municipal bond's credit rating before you invest. Learn a little about the locale that's issuing tax free municipal bonds, too. A city like Dallas that's weathered the recession well is a good bet, but an economic wasteland like Detroit presents serious risk. Once you've done your research and found some tax free municipal bonds that look solid, you can place an order through your brokerage. Tax free municipal bonds make great investments for diversification and shielding yourself through rough economic cycles.
 

Resources:

Bond terminology
Bond fundamentals

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