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Investing 101: What Are Municipal Bonds?

Mon Mar 03, 2014 03:57 EST

You've probably heard the commercials touting how municipal bonds supposedly "never lose a dime of principal," and how the money you earn from them is exempt from federal, state, and local income tax.

Sound too good to be true?

In the days of yore, municipal bonds were considered one of the "safest" investments because of the low risk of default. But in this age of major city bankruptcies (think Detroit or San Bernardino), investors may have reason to doubt the stability of municipalities around the country.

So we spoke to Marilyn Cohen, founder and chief of investment strategy at fixed income investing firm Envision Capital Management, and Brandie Farnam, Certified Financial Planner at LearnVest Planning Services, to examine exactly what municipal bonds are, whether they're as useful as they're purported to be, and whether they may be right for you.

What Are Municipal Bonds?

Also known as muni bonds or munis, these bonds (loans that you grant to an entity in exchange for interest payments) are issued by a state, county, or even a town or a city. In exchange for loaning money to the local government, the earnings you make on municipal bond investments are exempt from federal taxes and often from state and local taxes too.

Muni bonds are usually seen as "safer" investments because, although it is possible for a municipality to go bankrupt, the chances of default on the loan are relatively low. That said, due to the reduced volatility and the tax benefits, muni bonds generally yield smaller profits for investors than corporate or other taxable bonds.

Reason Number One to Consider Buying a Municipal Bond: Tax Savings

According to Cohen, investing in municipal bonds usually work best for people who are in a high tax bracket because the tax savings benefits of munis are higher for them. That said, you don't necessarily have to be in the absolute highest tax bracket for munis to be helpful. "For example, let's say I'm not in the highest bracket but the second-highest bracket, and I live in New York," Cohen explains. "New York takes so much through state income tax and city tax that my tax burden is already higher than it would be [for others in the same bracket who live elsewhere]."

"Munis are really for people in the highest income tax brackets because they can be triple-tax-free," Farnam adds, referring to federal, state and local taxes. "But in order to enjoy that benefit, you have to buy bonds sold by your home state's government." Translation: If you live in Ohio, buying Californian munis wouldn't absolve you of state or local taxes.

There's yet another way that municipal bonds can come in handy. For people who are married with an adjusted gross income over $250,000, munis are one of the rare ways to circumvent the additional 3.8% tax that's associated with the Affordable Care Act and levied on high earners. In fact, notes Cohen, this is why many baby boomers are opting for munis -- sometimes out of emotion more than pure financial sense. "If you feel taxed every which way and back," she says, "you might be O.K. with lesser gains in order to avoid being taxed on that extra amount."

When comparing the tax-free yield of a muni to the taxable, higher yield of a regular bond, there's a formula you can use to figure out which may be better for your own situation.

Editor's note: This story by Allison Kade originally appeared on LearnVest.

To read more from LearnVest, see the following articles:

Detroit's Debt: How a Major City Goes Bankrupt

Bonds 101: Understanding How Bonds Work

1099 vs. W-2: How Independent Contractors and Employees Differ
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