Tax-free municipal bonds are the largest component of the municipal bond market and there are many types of tax-free municipal bonds. According to Barron’s, the total market for state and local municipal debt obligations is greater than USD 3 trillion. Lenders to the municipal market are individual investors, mutual funds, money market funds, insurance companies (Property & Casualty insurers), and commercial lenders.
State and local municipal governments borrow money from time to time. Selling bonds is usually the fastest way for the borrower to access funds. According to FINRA, the Financial Industry Regulatory Authority, municipal bonds (munis) are the only type of tax-free bonds municipal available to U.S. investors. Let’s look at the types of tax-free municipals you’ll find in the market.
Tax-Free Municipal Bond Types
Tax-free municipal bonds are classified in two types, according to the money sourced used to pay interest on them:
- General Obligation (GO) bonds: General obligations are backed by the issuer’s full faith and credit. In other words, the issuer’s authority to tax residences is the source of funds necessary to pay interest and repay principal in timely fashion.
- Revenue (Rev) bonds: Revenue bonds derive funds for interest and principal repayment through money generated by a certain project. For instance, a revenue bond intended to fund highway construction might use tolls collected to pay bondholder interest and repay principal.
Muni bonds traditional pay a certain amount of interest to their bondholders each year. The amount of interest to be paid bondholders is called the coupon. The coupon represents a specific percentage of the bond issue’s face value and the amount each bondholder receives when the bond comes due at maturity.
Some munis are sold at a percentage of face value, or at a discount. These tax-free municipal bonds don’t pay current interest. The bondholder receives accrued interest at maturity:
- You purchase an original interest discount (OID) tax-free municipal bond from your bank. You want to let the money grow, so earning tax-free interest in lump sum when the bond matures is a benefit. You don’t bear the same reinvestment risk that other bondholders have if they receive two interest payments a year (if they don’t spend funds as income).
- If interest from your municipal bond isn’t considered a tax-exempt issue, the IRS considers muni bond interest as ordinary income, just like employer wages, interest on savings, or dividends earned from stocks.
Naturally, don’t buy a tax-exempt municipal bond in a currently tax-sheltered retirement plan. Use higher coupon taxable bonds instead.
Tax-Free Status of Municipal Bonds
Not all municipal bond issuers enjoy tax-free status. Some municipal bond interest is considered taxable, and bondholders pay taxes on the interest they earn:
- In order to qualify for tax-free status, bond issue proceeds must be deployed to benefit the general public in the municipality. For instance, if the municipal government needs to build a school or hospital, these projects benefit the general public.
- If the bond issue proceeds are used to build a new baseball field or support the local government’s underfunded pension plan, the issue probably won’t qualify for tax-free municipal bond status.
Municipal bond interest is sometimes exempt from just state and/or local taxes. If you’re a resident of Massachusetts or another state income tax, you’ll probably want to invest in a local municipal bond issue to protect your income from local taxes.
Tax-Free Municipal Bonds and Capital Gains
Municipal bonds can be bought and sold in the secondary market like other bonds. Prices of municipal bonds rise and fall with interest rates and investor demand. If you purchased a long-term bond five years ago and interest rates are lower today, you may be able to sell the bond for more than your cost basis. Of course, you’ll need to reinvest the money at a lower yield in that case.
If you sell municipal bonds and book a capital gain, these gains aren’t tax-free even if the interest on your bonds is tax-exempt:
- Let’s say you purchase a USD 10,000 municipal bond at a discount of USD 9,000. Interest rates decline and the price of your bond rises to USD 9500. The capital gain of USD 500 is taxable.
- If you held the bond for at least a year, you have a long-term capital gain. If you booked a short-term gain, you’ll pay tax at the ordinary income rate.
If you own municipal bonds and the prices of your bonds have dropped and you have other capital gains to offset, you may consider a tax swap. Although there are many variations of the municipal bond swap, you generally sell municipal bonds to book the loss. You then repurchase similar but not identical bonds to maintain the municipal bond portfolio. Consult your financial advisor before performing a municipal bond swap.
Tax-Free Municipal Bonds for Income
If you’re looking for a low-risk way to shelter income, tax-free municipal bonds might be right for you. Ask your financial advisors about the tax-exempt status of any municipal issue you’re considering. As long as the bond proceeds are earmarked for expenditures to benefit the municipality’s general public, your coupon interest should be considered exempt from federal income taxes.
Buying a state municipal bond issue can help you save more money. If you don’t live in one of the seven states without a current income tax—Alaska, Tennessee, Florida, New Hampshire, Nevada, South Dakota, Washington, or Texas—you might make more money buying a local issue.
Understanding the types of municipal bonds is also important. If you’re most comfortable with general obligation issues, for example, ask your broker, banker, or financial planner to let you know when these issues are available.
It’s relatively to buy tax-free municipal bonds:
- Open a securities account with a registered municipal bond dealer or other broker-dealer registered and licensed to sell these securities.
- Most large banks and broker-dealers are registered to sell municipal bonds. Before deciding on the purchase of a bond issue, ask if your seller is a dealer or agent. You might pay more for the bond if the seller doesn’t own the bond in inventory.
- Plan to invest at least USD 5,000 in a municipal bond issue. If you have less to invest in municipals, consider municipal bond unit trusts or bond funds to gain access to tax-free municipal bonds.