What Are Tax Free Municipal Bonds And How Can They Benefit You

Today it seems as if the government has a tax for just about everything.  In fact it can seem as though it’s next to impossible to invest money without being taxed in some way or another.  In this article I going to show you a way to avoid those taxes, they are called tax free municipal bonds.

What Are Tax Free Municipal Bonds

Municipal tax free bonds are IOU’s issued by the states and local areas like cities and counties.  They issue these bonds to help raise money for things like road improvements, schools, and hospitals.

The reason they are tax free is because it was deemed in the sixth amendment by the federal government that it would burden the states to raise money for the projects they would need money for.   Therefore federal taxes would be exempt and if you lived in the state you bought the municipal bonds tax free you would also be exempt in that state as well from paying taxes.

Their are two types of municipal bonds, the first is general obligation bonds.  These bonds are paid back on taxes that are paid by the tax payers.  These bonds are for road, school, and hospital projects that need to be done in states.

For example, if a hospital wanted to add a new wing on to it existing hospital they could issue a bond to fund the project and once it’s done it would pay back the bond holders though taxes collected by the state.

Then their are revenue municipal bonds which are issue by local governments like your local utility company.  However unlike general obligation municipal bonds revenue municipal bonds are not paid back by the tax payers but the revenue earned by the company itself.

For example if local power company need to make improvements in your town they would issue a revenue municipal bond to cover the cost and the bond holder would by paid back by the revenue earned by the power company.

Benefits Of Municipal Bonds

So now that we have a basic understanding of how tax free municipal bond funds work let cover some of the benefits as to why having these types of investments could benefit you.

  • Federal and State Tax Benefits. First off, as I mentioned earlier you get the exempt benefit of not paying any federal taxes and no state taxes if you buy the bond within the state you live in.  However, if you are someone who pays taxes in a very high tax bracket you will find the most benefit from this.
  • It’s A Safe Investment. Municipal bonds are also known as very safe investment since it’s backed by the state.  This does not mean you couldn’t loss money with this kind of investment but the chances are less likely.
  • Easy to Liquidate. Finally, with municipal bonds they are very easy to liquidate since they can be bought and sold at any point and time.

Where To Get Started

Are tax free municipal bonds right for you?  To know for sure their is a simple formula that you can run to find out if a municipal bond is better or a taxable bond like a corporate bond will pay out better.

This formula will tell you what kind of return you will need to earn on a taxable bond in order to out do the tax free benefit the municipal bond offers.  The formula is the tax exempt yield divided by 1 minus your tax bracket. (tax exempt yield / 1 – tax bracket)

For example if you had a 15% tax bracket and earned a 6% yield on your investment it would look something like this .06 / (1-.15=.85).  The answer is 7.06% which means if you could find corporate bond that would earn more than that you would be better off with that than a municipal bond.

Finally, I should also mention that their two ways to purchase a municipal bond.  The first is buy it straight out from a broker dealer who may require you to invest as much as $25,000 and then the other option is buy them through a mutual fund which will only cost you around $1000 to start in most cases.

If you would like to learn more contact your financial professional and ask them more about how municipal tax free bonds can benefit you.

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