With the tax return deadline approaching, taxes are certainly top of mind for many investors. One of the most common goals that I hear from my clients is to save money on taxes. So, what are some methods to do this? A quick way to lower your tax liability is to seek out tax free income. Municipal bonds are one of the few investment vehicles that actually provide tax free income. This makes them especially attractive to investors who are looking for investment growth or income but do not want to add to their overall tax liability.
What are municipal bonds?
Let's start by defining one individual municipal bond. An individual municipal bond is a debt security issued by a state, city, county, or other government entity to fund day-to-day obligations and to finance capital projects such as building schools, highways, sewer systems, etc. Essentially, you as the investor, are loaning these municipalities money and they are promising to pay you back plus interest.
Investing in one individual municipal bond can expose you to default risk because your repayment depends on the health of the municipality. To mitigate some of that default risk, it's usually a better idea to invest in a municipal bond fund. A municipal bond fund is a mutual fund that invests in several individual municipal bonds, usually 50 or more. These funds offer investors diversification against individual issuer risk that is present in individual municipal bonds.
What are the benefits of municipal bonds?
Municipal bond funds are one of the few investments in the market that offer a tax exemption. One of the main benefits of investing in municipal bonds is that the interest that they pay is 100% federally tax free. In addition, if they are issued by a municipality in the state in which you live, the interest is both federally and state tax free. Municipal bonds are a unique investment. Most other non-retirement investments require you to pay income taxes or capital gains taxes on the growth of your investments. Even the small amounts of growth you see in your savings accounts and in a CD is subject to taxes.
Municipal bonds also typically pay a higher interest rate than banking vehicles, but are still considered a conservative investment when compared to stocks and non-government bonds. Municipal bond funds also have the added benefit of liquidity. Municipal bond funds allow you to buy more shares and liquidate your shares on your own time. There is no specific holding period.
Where do municipal bonds fit into my financial plan?
Municipal bonds are not free of risk. Therefore, you should still utilize your checking or savings accounts for your emergency fund and to fund goals within 2 years. However, for money that won't be used for 2 or more years, municipal bonds are a great alternative to a savings account. Like a savings account, they are conservative and don’t fluctuate too much on a day to day basis. They typically will pay higher interest than a savings account and the interest that they do pay is tax free. So while they may not be a great fit for a long term investment or inside your retirement account, they work great in a non-retirement portfolio.
To see if municipal bonds make sense in your financial plan, schedule a meeting with Tori or me. We would be happy to analyze your situation and see if municipal bonds are a suitable investment.
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