If you like steady income but you don't like taxes, municipal bonds could be just the ticket. Municipal bonds - "munis" for short - are issued by state and local government entities in order to raise money for projects, operations, and capital expenditures.
The biggest allure of municipal bonds is that the interest income they pay is exempt from federal taxes, and in some cases, it is also exempt from state and local taxes for residents of the state in which the bond is issued.
Munis come in two basic types, revenue bonds and general obligation bonds. Revenue bonds are used by state and local government entities to raise money for projects such as schools, roads, stadiums, and water and sewer projects. General obligation bonds are used to finance municipal or state operations and capital expenditures.
Municipal bonds are offered in denominations of as little as $1000, although a$10,000 minimum is more common. You buy municipal bonds at face value, collect your tax-exempt interest throughout the term of the bond, and receive your principal back in full when the bond matures.
In additional to the tax benefits of municipal bonds, they are also considered to be very safe investments. They are not quite as safe as U.S. Treasury securities because they are not backed by the federal government. But of the thousands of different municipal bonds issued in the past decade or so, only a handful have defaulted.
The drawback to municipal bonds is that they pay a fairly low yield. But because of their tax advantages, their yield is not a true reflection of the after-tax return. For instance, for an investor in the 31-percent tax bracket, a 4-percent tax-exempt bond would provide nearly the same after-tax return as a taxable 6-percent bond.
Municipal bonds are not for every investor. But for conservative investors in search of tax-free income, they're an ideal choice.
Introduction to Junk Bonds
Who should buy municipal bonds?
Municipal bonds are most attractive to investors looking for tax-exempt income. They are very popular with affluent, conservative investors. About 5 million Americans hold municipal bonds in some form, whether it's an individual bond, a bond mutual fund, or a unit investment trust.
Who should not buy municipal bonds?
Municipal bonds are not appropriate for investors invested in capital appreciation, nor would they be appropriate for aggressive investors looking for a high total return. Municipal bonds would definitely not be suitable for tax-favored retirement accounts, such as IRAs, SEP's, and 401k plans. The tax exemption that municipal bonds provide would be lost in a tax-advantaged retirement plan. Among fixed-income investments, you would be better served to use higher-yielding taxable bonds for a tax-advantage retirement account.
