Tax Benefits of Investing in Municipal Bonds

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If you've been burned by stocks, you may be wondering about investing in bonds, hoping to get a steady, predictable flow of income. But what about taxes?

Because you keep getting payments of interest on your bonds, you're often exposed to taxes on your interest income unless you invest in U.S. Treasury bonds, or municipals, making a loan to the federal government or a city.

• Everyone wants U.S. Treasury bonds, these days, so the prices have gone up, and the yields have sunk. And you have to pay federal taxes on that income. (The income is tax free on your state return.)

• Municipal bonds get less respect, so their prices tend to be a bit lower, though their yields are close to those of Treasury bonds. But income from municipal bonds is exempt from federal taxes, and if you live in the same state as the agency issuing the bond, the income may be exempt from your state income tax, too. So you get a bigger taxable equivalent yield with munis.

Municipal Bond Yields

As you move to higher tax brackets, you get even more benefit from the tax exempt status of municipal bonds, so the real yield is even greater than the income you receive from the bond. Imagine a situation in which a municipal bond offers a 4.7% yield.

• If you're in the 28% federal tax bracket, the 4.7% yield has a taxable equivalent yield of 6.5%. In other words, you need to get a 6.5% yield from a taxable bond to equal the 4.7% payout of the municipal bond.

• If you're in the 33% federal tax bracket, the 4.7% municipal bond yield is the equivalent of 7.0%.

• If you're in the 35% bracket, your yield is 7.2%. And if you buy a bond issued within your state, you can usually shield the income from your state income.

You can buy individual municipal issues directly from a broker, or you can purchase shares in a mutual fund that owns a diversified portfolio of municipal bonds.

Buying From a Dealer

When you buy the bonds directly from a dealer, you are almost guaranteed to get your initial investment (the principal) back if you hold the bond until it matures. (The only catch is if the municipality that issued the bond declares bankruptcy. Fortunately, that is an incredibly rare occurrence.)

But individual municipal bonds are sold in increments of $5,000, and you need a $25,000 minimum investment to get the best price.

Buying Through a Mutual Fund

For about $1,000, you can buy shares in almost any mutual fund that specializes in municipal bonds.

Downside: You aren't guaranteed that your principal will be returned because a mutual fund owns dozens of municipal bonds that the manager actively trades. So when you sell your municipal fund shares, the value of the investment could be higher or lower than your initial investment, based on the current value of the bonds the manager owns.

Caution: Only the income from a fund is tax-exempt. If you sell your municipal fund shares for more than your initial investment, you have to pay tax on that capital gain.

Tip: Avoid mutual funds that have portfolios with the longest maturities because they are hit hardest when interest rates rise. Look for funds full of intermediate-term issues with average maturities of ten years or less.