Municipal Bonds
Do Municipal Bonds Have a Place in Your Portfolio?
Unlike most other bonds, municipal bonds have one tantalizing feature. The
income is tax free.
That alone does not make munis right for everyone. It does mean that almost
every investor should explore whether municipal bonds and municipal bond funds
make sense for them.
When you invest in a muni bond, you lend money to a state or local government to
build roads, schools, hospitals, or other public works project. In return, you
receive regular interest payments plus your principal back at an appointed time
in the future, known as the bond's maturity date.
The risks and rewards of municipal bonds are fundamentally the same as other
types of bonds. Their value fluctuates with changes in interest rates. They are
issued by governments and government agencies, which are generally less likely
to default and are considered less risky than similar corporate bonds. The
tax-free income provided by municipal bonds makes them attractive to many
investors, especially those in higher tax brackets.
Because the interest they provide is free from taxes, municipal bonds offer a
lower yield than taxable bonds with similar maturities. To determine whether
that lower yield is the better deal you should compare the taxable investment to
what's called the municipal bond's tax equivalent yield. For example, suppose
you're trying to decide whether to invest $20,000 in a tax - free municipal bond
that pays 6% or taxable investments that pays 8%. At first blush, the 8%
investment may look better. After all, the 8% investment should earn $1,600
($20,000 x .08) while the municipal bond should earn only $1,200 ($20,000 x .06).
However remember, you still have to pay income taxes on that $1,600. If, lets
say, you're in the 36% tax bracket, that $1,600 falls to ($1,600 - $576 in
taxes). Suddenly the $1,200 return looks a lot better.
Suppose you are in the 15% income tax bracket. Now the taxable investment is
worth $1,360 ($1,600 - $240 in taxes), and would be the better choice.
When you invest in municipal bonds, you'll have to decide whether to invest in
individual bonds or bond funds.
Many municipal bond funds may be purchased without sales charges or commissions
and offer relatively low minimum investments. Bond funds generally distribute
income monthly, which can be a plus for those interested in supplementing their
income. But the yield on a bond fund generally fluctuates depending on the
maturities of the bond held within the fund's portfolio. And bond funds
typically have no maturity date, so there is no assurance your principal will be
returned to you.
An investment in individual municipal bonds generally starts at $10,000 and is
only available through brokers, which therefore involves commissions. Because
you're buying a specific municipal bond, its interest rate will be fixed.
Interest payments will likely be made to you semiannually. When your individual
bond matures, your principal will be returned to you.
Questions & Answers:
Should I include municipal bonds in my retirement account?
Generally, no. The income from municipal bonds is tax - free, so you can gain no
additional benefits by including them in a Roth or traditional IRA, which offer
their own tax advantages. Furthermore, because municipal bonds offer lower
yields than taxable bonds in exchange for their tax - free status, including
them in your IRA could wind up costing you money.
Are munis always tax - free?
No. A municipal bond's interest payments are generally free of federal taxes.
Oklahoma munis are also free of state taxes, out of state munis are not.
Oklahoma residents should look to these tax exempt state bonds for investment
over out of state single tax exempt issues.
This information is for educational purposes only and is not recommended any
particular investment product or service.
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