Investing Close to Home: The Basics of Municipal Bonds

What are tax-free muni bonds? Learn the unique benefits and risks of this debt-security investment vehicle.

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https://tickertapecdn.tdameritrade.com/assets/images/pages/md/Muni bonds: tax-free investing in your community
5 min read

Key Takeaways

  • Muni bonds are debt securities issued by cities, states, and other municipalities to fund capital expenditures
  • Interest payments from muni bonds are generally exempt from federal income tax
  • Muni bond rates are often lower than those for higher-risk corporate debt

If you’re aiming for something near the polar opposite of “hot investment topic” territory, you may run across municipal bonds. But although tax-free muni bonds—aka munis—may not be the rock stars of the investment world, they do possess several unique attributes that might make them worth a look. Their range of focus is highly regionalized, and their financial impact often does not exceed the boundaries of a city, county, or state. And perhaps because of their relatively narrow scope, munis rarely get the spotlight.

But tax-free muni bonds comprise a massive $3.8 trillion market (as of 2017, according to the MSRB), and they offer unique characteristics and potential benefits that might make them worth considering as an investment vehicle. And generations of retirees and investors seeking a relatively safe, diversified, and tax-advantaged way to generate steady income appear to have flocked to municipal bonds.

New to municipal bonds? Let’s take a closer look at what these fixed-income securities might have to offer. Specifically:

  • What are municipal bonds, and how do they work?
  • Are muni bonds tax-free? What are the potential benefits of tax-free muni bonds?
  • What are the potential disadvantages of munis?

What Are Municipal Bonds and How Do They Work?

States, cities, counties, and school districts are among the municipalities that issue muni bonds to raise capital for public works—capital expenditures that typically involve building, maintenance, or upgrades of roads, bridges, buildings, and other infrastructure.

Muni bonds are considered “debt securities”—tradable financial instruments with predefined principal amounts, interest, maturity, and other terms. Munis are also considered fixed-income securities, meaning that, as an investor, you can expect to receive periodic interest payments (typically every six months) of a non-variable amount until the bond matures. And unless the bond issuer defaults—a rare occurrence with munis—you can expect to be repaid the principal amount you had initially invested.

Perhaps what investors find most attractive about municipal bonds, and what differentiates them from other fixed-income securities, are the tax advantages.

Putting Money on Munis? Know the basic types of municipal bonds.

Benefits of Investing in Municipal Bonds

Here’s a short list of the potential advantages that distinguish munis from other bonds:

  • Munis are generally tax-free at the federal level. Interest payments from municipal bonds are generally exempt from federal income tax, which can be particularly attractive to investors in high tax brackets. 
  • Munis can also be tax-free at the state or city level. Interest from municipal bonds issued by your home state may also be exempt from state and local taxes.
  • Munis can be a “safe haven.” Depending on the issuer’s creditworthiness, municipal bonds typically have a lower rate of default compared to, for example, higher-risk corporate bonds. 
  • Munis offer a way to invest in your own community. Does your local school district need a new library or larger classrooms? Municipal bonds can offer opportunities to invest in something you view as tangible and meaningful and that you, your family, and your neighbors can benefit from.

Potential Drawbacks of Investing in Municipal Bonds

As with every investment, municipal bonds also have risks and drawbacks. Here are a few to consider:

  • Less competitive interest rates. Despite varying tax-exempt benefits, municipal bonds might offer lower interest payments than similarly rated corporate bonds. And when the Federal Reserve raises interest rates, yields for some muni bonds could end up below the average market rate.
  • Profits from sales are taxable. Although your interest payments may be tax-free, any profits you make from selling your municipal bonds before maturity, if you sell them at a profit, may be subject to taxation.
  • Might subject you to the AMT. Interest income and capital gains on municipal securities may be subject to the Alternative Minimum Tax (AMT).
  • Interest may negatively affect Social Security benefits. Although interest payments from municipal bonds may not be subject to federal taxes, the IRS considers those payments as income when calculating taxes on Social Security benefits. And, if the combined amount of half of your Social Security benefit and other income (including your municipal bond interest payments) exceeds $44,000 for a joint return (or $34,000 for an individual return), then up to 85% of your Social Security benefits may be taxable.
  • Muni defaults can happen. Not often, but there is always risk in investing, and some municipalities have defaulted on debt. Be sure to exercise due diligence before investing in municipal bonds (or any bond for that matter) and seek guidance from investment professionals when necessary.

Are Municipal Bond Investments Right for Me?

Municipal bonds may be a conservative means to diversify your portfolio and generate a stable stream of income, but, like most everything, munis carry a certain degree of risk. There’s also some opportunity cost—meaning that returns could be lower than what you might have received if you invested in something with a higher risk/reward factor. So despite the potential benefits, muni bonds aren’t for every investor.

Before investing in municipal bonds, be sure to do your homework. Weigh the pros and cons, not only of municipal bonds (or bonds in general), but also for the real communities where munis are at work.

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