The smaller government bodies, like cities or local school boards, have the ability to issue debt obligations known as municipal bonds. Federal taxes do not have to be paid on the money gotten through municipal bonds. It is the state and local laws that determine if city, state, and local taxes need to be paid on them.
Why are Muni Bonds Tax Free?
These bonds are used to build things like roads, schools and other public projects like stadiums and parks. If a person decides to buy a municipal bond, he is lending money to his state or municipality in the amount of the bond he purchases. You earn money in return for lending the money. You are given back all the money you invested once the bond is fully matured.
The muni bonds are exempted from federal taxes, because they are issued by a different branch of the government. It is possible for a state to tax the interest earned on these bonds, but most states chose not to attach a tax so that more people are likely to invest in the bonds.
Types of Muni Bonds
There are three types of municipal bonds. The general obligation bond of the issuing agency is backed by a full faith and credit clause which is in the form of the municipality’s taxing power The revenue bond is guaranteed by the money earned from a specific project, authority, or agency. It is important that these bonds do not have a full faith and credit clause. Therefore, if the project they are supporting is not a quality project, the full amount of the bond may not be returned. The industrial development bond (IDB) is used to support the purchase or building of an industrial facility that will be leased by private businesses.
How to Purchase a Muni Bond
One can use one of two methods to invest in a municipal bond. The first option is to buy them from a broker who will inform the buyer that he has to purchase them in $5,000 par values and the buyer must make a $25,000 investment. The second option is to purchase them through a mutual fund. The average investor will get municipal bonds through a mutual fund because these only require a minimum investment of $1,000 – $2,000.
If a person does not desire to build a portfolio of securities, he/she can find various municipal bond funds and exchange-traded funds on the market. In order to assist investors in choosing which funds to invest in rating agencies like Moodys and Standard & Poors developed a rating system. One of the best bond-buying opportunities is when the interest rates on the bonds drop. It is possible for investors to be guaranteed high returns and to be able to defer any interest income.
The default rates on municipal bonds are quite low, making them a safe investment. The reason for this is that each year a state has to balance their budget in a way that all debts will be paid.