How munis help you save on taxes
As we described in our previous post, there are two ways to make money from municipal bonds:
- Collecting interest payments
- Selling the bonds for a higher price than what you paid before they mature
Because the latter relies on strong market conditions in order to turn a profit, many people who choose to invest in muni bonds do so for the ability to collect interest while holding the bonds until they come due. (For this reason, muni bonds are sometimes recommended as a long-term investment strategy, as opposed to a short-term approach.) Interest payments on muni bonds are typically disbursed two times a year. When considering a municipal bond investment, one of the first things you’ll want to know is how much interest the bond is paying. The higher the interest, the more money you’ll potentially make simply by holding onto the bond until its maturity date.
One major benefit of muni bond interest is that it’s usually exempt from federal taxes. This can make a difference if you’re already in a high tax bracket or are hovering on the border between two tax brackets.
When you earn interest from another source, like a savings account or corporate bond, that interest is taxed as ordinary income. But when you earn interest from a tax free muni bond, you usually won’t have to fork over a portion of your profit to federal taxes. Even better, if you purchase municipal bonds issued by your own state, the interest you earn from those bonds may be exempt from state taxes as well.
Keep in mind, however, that while you can make money from muni bonds by selling them at a premium, any profit you make on the face value, or principal, will still be subject to capital gains taxes. The tax-exempt status of muni bonds refers only to money made from interest payments.
A Chance to Invest Locally
Municipal bonds offer a unique opportunity to invest not only in your own local area, but in the things that matter the most to you.
Let’s say you’re passionate about early education. If that’s the case, you can search for municipal bonds that are being used to fund the construction or expansion of a local school system. Concerned about the environment? You can look for municipal bonds issued by a local utility or power authority to make their infrastructure more energy-efficient.
The great thing about municipal bonds is that you can choose to support your local town or city, or a specific project from which you stand to benefit should it get funded and subsequently completed. In other words, you have the potential to not only make a profit on the bonds themselves through interest payments (and a possible resale), but to benefit from the end result of the initiative the bonds are issued to support.
Neighborly is building a modern public finance platform that will give you opportunities to invest directly in the places and projects that are most important to you. Though your motivation may stem from a desire to increase your own personal wealth, by investing in municipal bonds, you’ll be supporting your city or town and potentially improving the quality of life it can offer its residents.
Relatively Low Risk
While there’s no such thing as a risk-free investment, municipal bonds have historically been less risky than stocks and corporate bonds. Muni bonds have a much lower default rate than corporate bonds, which means you’re less likely to face missed interest payments. In fact, over the past 45 years:
- There has never been a default on a AAA-rated municipal bond
- There have been only 71 Moody’s-rated municipal bond defaults in total over that same time period
Based on historical data, muni bonds are 50 to 100 times less likely to default than comparably rated corporate bonds. And from a recovery standpoint, municipal bonds also tend to fare much better in the event of a default.
The lower the risk of default extends not just to interest payments, but to the ever-important repayment of principal. Don’t forget, when you invest in a bond, you eventually want to recover the full principal amount you put in.
While corporate bonds typically have higher yields than municipal bonds, they also tend to come with more risk. And although muni bonds are not devoid of risk, you can protect yourself by doing your own research and reviewing credit ratings before making your purchase. Remember, the higher the rating, the less likely the chances of a default.
But What About the Flipside?
Clearly there are a lot of good reasons to purchase municipal bonds, but before you make any investment decisions, it’s important to understand the differences between the various investment opportunities you likely have.