You may have heard that municipal bonds are good investments. The sale of municipal bonds make it possible for a city, county, or state governments to issue municipal bonds for the building of schools, highways, hospitals, and other such projects for their locality.
Municipal bonds look good to the investor because these municipal bonds are tax exempt when it comes to federal taxes and can be free of state taxes if bought in the investor’s own state (But don’t miss Tip #2 Below!). Such municipal bonds may even be tax exempt when it comes to personal property tax. Certainly, if you live in a high tax state, such an investment will be particularly advantageous.
In addition to the potential interest income, investors may be drawn to municipal bonds because of the relative safety of this kind of investment. Interestingly, investors may also be interested in the projects being financed for personal reasons or because those improved roads or schools may indirectly benefit their other business interests.
Does this description sound like you and your current financial interests? Certainly, municipal bonds are worth looking into for the tax advantages that put money in your pocket, the safety of the investment, and your possible interest in the state or municipal (city, county) projects that can be completed due to the sale of municipal bonds.
You need to know more:
There are two categories of municipal bonds:
1)General Obligation bonds
2)Revenue Bonds.
Their difference centers on the collateral to back them.
General Obligation bonds, with the appealing nickname of GO Bonds, are backed by the fact that city, county, or state has the advantage of being able to raise revenue through taxes.
Revenue municipal bonds are offered by an entity at the city, county, or state level. A utility company such as a water company is a good example of such a revenue municipal bond. That utility, that business, has an obligation to pay the interest and does so from the revenues that come in from the business. In this case, the income is generated as customers pay their water bills. The bond holders are paid from this revenue.
Do you wonder how these tax free municipal bonds compare to other bond investments you may be looking at? There is a way to compare them. You will want to get the greatest after-tax return. The taxable equivalent yield formula will help you see which may be the best for you.
To calculate this information, you will need to know about Yield and will need to know your tax bracket (as a percent).
USE THE FORMULA-
What is the YIELD of the tax-free municipal bond you are considering? For our formula, let’s say it’s 5%.
What is your tax bracket? As an example if it is 15%, you calculate 1 – .15 = .85. We are going to use the .85 in our formula.
Next: Our YIELD divided by our .85 (representative of the 15% tax bracket), gives us:
.05 divided by .85 equals is 0.0588, which is 5.88%. If you can invest in a taxable bond with a YIELD better than this 5.88%, you should pursue that taxable bond. These numbers are used to illustrate how this formula works. Your prospective municipal bond may present a different yield and your tax bracket may be higher or lower than the 15% example used here. Do the math, as they say, and use the quotient of this basic division formula as a measure of whether you can do better elsewhere. Typically, investors in higher tax brackets do better in tax-free municipal bonds.
TIPS and OTHER POTENTIAL BENEFITS OF INVESTING IN MUNICIPAL BONDS:
1. Do some research-Get information about the bonds offered: 1.) Who will be servicing the interest payments on the bonds, and 2.) What is the economic health of the issuing city, county or state. Factors contributing to good economic health are whether the state or local government, as a community, is prospering and growing, has diversity, can show a solid payment history on prior financial responsibilities, and currently has a population of at least 10,000 residents.
2. Find out about Reciprocity Agreements- Look at neighboring states, cities, or counties. Perhaps a neighboring state, city, or county has developed reciprocity agreements. Such a reciprocity agreement may make bonds from these neighboring jurisdictions available on a tax-exempt basis as well.
3. Consider the factor of Changing Interest Rates -Changes in interest rates affect municipal bonds. If the current interest rates go down, investors will benefit by an increase in the value of their bonds. The flip-side is also true, so factor that possibility into your decision.
Now you have more information and, yes, municipal bonds deserve a closer look when it comes to making wise investments. Their tax-exempt status, their relative safety, and their contribution to your state or municipality are all good reasons to consider investing in municipal bonds.