What Are the Advantages of Tax-Free Municipal Bonds?
One of the most frustrating parts of investing is dealing with capital gains taxes. Holding an investment for less than 12 months will cause you to get taxed at your income bracket. Holding an investment for more than 12 months can reduce your capital gains tax. However, did you know that there is a way to completely avoid paying tax on your investment? It’s called investing in tax-free municipal bonds and it’s one of the best-kept secrets in investing.
What Are Tax-Free Municipal Bonds?
A tax-free municipal bond is a bond that is paid out by a local, state, or federal government. These bonds are usually exempt from federal taxes and are sometimes exempt from state and local taxes. These bonds are used to help infrastructure around the country.
Example of a Tax-Free Municipal Bond
The state of Florida wants to build a new toll highway at a cost of $200 million. To pay for the cost of the toll highway, the state sells $200 worth of municipal bonds which pay 4.85% per year for 15 years.
Pros
There are a number of compelling reasons why you will want to consider tax-free municipal bonds. Here is a look at their top advantages
Tax exemptions
Most tax-free municipal bonds are exempt from federal taxes and are sometimes exempt from state and local taxes. This makes tax-free municipal bonds attractive for investors looking to lower their overall taxes.
Safe
Most tax-free municipal bonds are extremely safe and the risk of default is low.
Currently pays better than money market, short-term treasuries, or CDs
Compared to other safe investments such as money market funds, short-term treasuries, or CDs, you will get a better return in investment when you factor in its tax advantages.
Cons
On the other hand, there may be some reasons why tax-free municipal bonds are not the best investment for some. Here are the cons of tax-free municipal bonds.
Pays less interest than corporate bonds
Tax-free municipal bonds typically pay less than municipal bonds.
Doesn’t hold up well during inflation
When there is high inflation, tax-free municipal bonds will not be able to keep up with the rise in prices. This means that you can actually lose buying power after your returns on this type of investment.
Can default in extreme cases
There is an outside risk that a tax-free municipal bond can default. For instance, Detroit defaulted on its bonds in July of 2013.
How to Invest in Tax-Free Municipal Bonds
Currently, you can purchase a tax-free municipal bond through a number of online brokerages. You can also purchase tax-free municipal bonds through an exchange-traded fund or ETF. One example of a tax-free municipal bond ETF is the Vanguard Tax-Exempt Bond ETF (VTEB).
A More Tax-Friendly Way to Invest
If you are looking for a way to lower your overall tax rate and still gain a steady return on your money, then you should consider the many advantages that a tax-free municipal bond has to offer. Be sure to carefully weigh the risks and rewards of this type of bond purchase before making your final investment decision.
REFERENCE:
https://www.investopedia.com/articles/investing/040115/should-you-consider-muni-bonds.asp
