Consider yourself to be 65 years old. You have no debt, own your home outright, and have saved $500,000 throughout the course of your working life. You can invest in either ordinary corporate bonds or tax-exempt municipal bonds. Corporate bonds have a yield of 7%, while tax-free municipal bonds have a yield of 5%.
Is it possible for tax-free municipal bonds to lose money?
Municipal bonds or money market funds will give you interest if you want to invest for income. Just keep in mind that bonds can lose value, whereas money market funds are unlikely to. It’s also worth noting that, because municipal bonds are tax-free, you’re making more money than the interest rate suggests. You can deduct your tax savings when calculating the value of such a bond.
How much do tax-free municipal bonds pay?
According to an annual analysis by Moody’s credit agency, municipal bonds are one of the safest investments available, with an average default rate of 0.08 percent between 1970 and 2019.
Are tax-free bonds a good investment?
- Municipal bond interest is tax-free in the United States, however there may be state or local taxes, or both.
- Be aware that if you receive Social Security, your bond interest will be recognized as income when determining your Social Security taxable amount. This could result in you owing more money.
- Municipal bond interest rates are often lower than corporate bond interest rates. You must decide which deal offers the best genuine return.
- On the bright side, compared to practically any other investment, highly-rated municipal bonds are often relatively safe. The default rate is quite low.
- Interest rate risk exists with any bond. You’ll be stuck with a bad performer if your money is locked up for 10 or 20 years and interest rates climb.
Is it wise to invest in municipal bonds in 2022?
The key drivers of the municipal market are all positive, therefore 2022 is expected to see ongoing robust demand for municipal bonds. Taxes are first and foremost. Investors are still concerned about increasing taxes and will do everything possible to avoid them, keeping demand high.
How long must you keep municipal bonds?
Municipal securities, or “munis,” are bonds issued by states, cities, counties, and other government bodies to raise funds for public projects such as roads, schools, and other infrastructure.
Munis pay a predetermined amount of interest (typically semiannually) and refund the principle on a predetermined maturity date. The majority of municipal bonds are offered in $5,000 increments and have maturities ranging from 2 to 5 years to very long (30 years).
When considering a municipal bond investment, keep in mind that no two municipal bonds are alike, and carefully assess each one, making sure to get the most up-to-date information on both the bond and the issuer. See FINRA’s Investor Alert Municipal Bonds—Important Considerations for Individual Investors for further information.
Buying and Selling Munis
Some municipal bonds have a higher level of liquidity than others. Some bonds trade frequently, while others may go weeks without any activity (no interested buyers or sellers). Municipal bonds, in general, are more susceptible to supply and demand pressures than other fixed-income securities. As a result, you’re taking on more market risk: If your bond is out of favor with other investors when you need to sell it, the price you get in the secondary market will fall. Of course, munis, like all bonds, are susceptible to interest rate risk: if rates rise faster than your bond’s rate, the bond’s secondary market value drops.
Because of the overwhelming amount of muni bonds available and the tremendous competition among dealers for a piece of the pie, muni investment should be approached with caution. Do your homework, beginning with selecting an investment professional with a track record of success in municipal securities.
When considering a municipal bond investment, keep in mind that no two municipal bonds are alike, and carefully assess each one, making sure to get the most up-to-date information on both the bond and the issuer.
Munis and Taxes
The principal reason why most private investors purchase municipal bonds is to benefit from preferential tax treatment on the interest they earn. The great majority of municipal bond interest is tax-free in the United States. Indeed, municipal securities are the only ones that fall within this category.
Furthermore, if you live in the state or city that issued the bond, your interest income may be exempt from state or city taxes. Residents of all states are excluded from paying taxes on bonds issued by Puerto Rico, Guam, and other US territories.
The federal government does not exclude all municipal bonds from taxation. Municipal bonds that are taxable may be issued to fund projects that the federal government would not fund. To make up for the lack of a tax advantage, these bonds often have higher yields than tax-exempt municipal bonds, and are more in line with corporate or agency bond rates.
The AMT (alternative minimum tax) is a tax that some persons must pay. The AMT is calculated using a separate set of principles than your regular income tax calculation, but you must pay whichever calculation is higher. The AMT may apply to investors who buy “private activity” municipal bonds, which are bonds that aren’t solely used for government activities. Interest gained on these “private activity bonds” cannot be deducted under AMT rules, unlike interest earned on other municipal bonds, including 501(c)(3) private activity bonds, and may result in an AMT payment. Before advising a tax-exempt investment, a reputable financial adviser should assess your AMT liabilities. A tax professional’s counsel is also recommended.
What are tax-free bonds and how do they work?
Municipal bonds (sometimes referred to as “munis”) are fixed-income investments that offer better after-tax returns than comparable taxable corporate or government issues. Interest paid on municipal bonds is generally excluded from federal taxes and, in some cases, state and local taxes as well.
Are capital gains on municipal bond funds taxed?
Municipal bond capital gains are taxed as either short-term or long-term capital gains, depending on how long you have owned the bond. Municipal bonds are rarely retained in tax-deferred retirement plans since their investment returns are taxed as ordinary income when they are withdrawn.
Do you have to pay taxes on bonds with no interest?
Bonds with a zero coupon pay no interest for the duration of the bond’s existence. Rather, investors purchase zero coupon bonds at a significant discount to their face value, which is the amount the investor would receive when the bond “matures,” or matures.
Zero coupon bonds typically have long maturities, with many lasting ten, fifteen, or even more years. These long-term maturity dates enable a person to save for a long-term objective, such as paying for a child’s college education. A deep discount allows an investor to put up a small quantity of money that will rise over time.
In the secondary markets, investors can purchase several types of zero coupon bonds issued by a range of issuers, including the US Treasury, companies, and state and local government agencies.
Because zero coupon bonds pay no interest until they mature, their prices fluctuate more in the secondary market than other forms of bonds. Furthermore, even though zero coupon bonds do not require payments until they mature, investors may be subject to federal, state, and local income taxes on the imputed or “phantom” interest that accrues each year. Some investors avoid paying taxes on imputed interest by acquiring municipal zero coupon bonds (assuming they live in the state where the bond was issued) or the rare tax-exempt corporate zero coupon bonds.