While investing and earning returns on that investment is generally considered to be a good thing, it also generally requires that the taxpayer write a check to the IRS for its portion of the returns on the dividends or profits. However, when one invests in municipal bonds, there are tax advantages that help eliminate the obligation to pay Uncle Sam for the interest that is received. Combined with other advantages inherent in owning “munis,” there are many reasons why these bonds should be at least a part of an investment portfolio.
What are Municipal Bonds?
Municipal bonds are those that are issued by a state, city or other local governmental entity. These bonds are issued in order to fund a project. A majority of these municipal bonds are highly-rated and offer investors some safety in their portfolio. The rating is a reflection of the credit risk that an investor assumes when they buy the bond. The safer type of municipal bond is known as the general obligation bond. This bond is backed up by the faith and credit of the issuing authority. Revenue bonds are tied to a specific revenue stream which will be used to repay the bonds. Revenue obligations are considered to be more risky because investors may be out of luck if the revenue to repay the bonds does not materialize. This usually means that revenue bonds will pay investors a higher rate of interest.
Tax Advantages
Corporate and government bonds require that investors pay income tax on the interest that they receive from owning these bonds. There is an exception in the tax laws for interest payments received in connection with municipal funds. Investors are do not have to pay income tax on interest and may be exempt from state and local taxes as well on this interest. This means that your effective rate of return on owning these bonds increases due to the amount of taxes that you save. Note that municipal bonds are not entirely free from tax obligations. For instance, you are required to pay taxes on any profit that you make from buying municipal bonds.
Portfolio Diversification
Municipal bonds are a great way of adding some relative safety to your portfolio. While they may not result in your portfolio sharply escalating in value, they will pay back a steady return and make your taxes that much simpler. This type of investment can help you diversify your portfolio and give you a cushion if the rest of your portfolio declines in value. Municipal bonds are not as sensitive to economic fluctuations like stocks are so they can provide your portfolio will some shelter when there is a storm.
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