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4 things to know about tax-free municipal bonds
Paying tax is essential, but it’s not a likable obligation. Many investors often prefer to earn tax-free income. This is where tax-free municipal bonds come in. These are fixed-income investments, the interest on which are exempt from federal taxes, and in some instances, from local and state taxes as well. Tax-free municipal bonds are a popular way of earning tax-exempted income, and when these are reinvested, one can earn tax-free compounding of returns. Generally, municipal bonds offer higher after-tax returns as compared to the returns of similar taxable government or corporate bonds. Here are a few things to know about tax-free municipal bonds.
What are municipal bonds?
An interest-bearing debt obligation that is issued by a local or state municipality is called a municipal bond. Such bonds may provide the necessary financial support for general government needs. These may be also used to fund any public works’ projects. These projects usually include building new hospitals, stadiums, roads, and bridges. Legal entities such as port authorities and housing authorities may also issue municipal bonds. Municipal bonds or munis not only give tax-free earnings but also provide an opportunity to invest in the growth and development of one’s community.
They are not the same as corporate bonds.
There are several differences between municipal bonds and corporate bonds. The income earned from corporate bonds is completely taxable. However, the income from municipal bonds is tax-free, that is, it is exempted from federal taxes. Moreover, if one buys a municipal bond issued by the state they reside in, they will be exempted from state tax as well; local taxes will be exempted too.
Another notable difference between municipal bonds and corporate bonds is how they mature. While corporate bonds have term maturities, municipal bonds have serial maturities. Thus, municipal bonds have multiple maturity dates. A part of the principal amount matures with every maturity date for the entire period of the bind, that is, until the entire principal is paid off. Also, the interest rate will differ with each maturity date.
Also, municipal bonds are issued with principal amounts of $5,000, while corporate bonds are issued with principal amounts of $1,000. Another significant difference is that municipal bonds are available only through over-the-counter markets, while there are some corporate bonds that are listed only on exchanges. However, long-term munis may be similar to a few corporate bonds that have “call” provisions.
Call provisions imply that the issuer of a bond can choose an early retirement of the entire value of the bond on the call date. There is a high probability of utilizing the call provision in case the current rate of interest is lower than the coupon rate of the bond.
Not all municipal bonds are tax-free
However, income from “private purpose” municipal bonds are taxable unless it is specified that they are tax-exempt. Some municipal bonds may be taxed under the rules of alternative minimum tax.
Are there different types of tax-free municipal bonds?
The General Obligation (GO) bond is the most common type of tax-free municipal bonds. GO bonds are associated with any particular community project. The issuer of these bonds has the obligation to make the principal and interest payments on time. This makes them one of the most low-risk municipal investments. However, these bonds have lower yields as compared to the other types of municipal bonds.
Here are the other major types of municipal bonds:
Revenue bond: These tax-free municipal bonds are secured by a revenue source specified in the bond. The source can be airport fees or highway tolls. They have higher yields than GO bonds and are also riskier.
Commercial paper: This is short-term debt issued by governments to meet budget shortfalls, cash-management needs, and so on. These binds have maturities of less than nine months and are usually backed by a bank letter. Due to short maturity term, the yields from these bonds are generally low.
Private activity bond: This type of a bond is used for funding private projects that have tax exemptions under federal laws. These bonds have higher risks than general obligation and revenue bonds, but they also offer higher yields. The earnings from these binds may not be tax exempt.
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