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  • Tax Free Municipal Bonds

    Posted on August 24th, 2010 William No comments

    Municipal bonds, also known as munis, are a popular savings vehicle due to their tax-advantaged status: the interest on them is exempt from federal (and generally state) taxes. However, if you buy a bond issued in a different state than the one you live in, you will likely lose the state tax exemption. Read on to see if you should have some municipal bonds in your retirement portfolio.

    First, let's define exactly what a municipal  bond is. These are IOUs issued by the government to raise money for new projects; since you're effectively lending money to the government, these tend to be a fairly safe investment. However, this is not always the case; cities do go bankrupt, and lately it seems as if some states could do the same! In some cases, corporate bonds may actually be safer as well as paying more; be sure to do the appropriate research!

    There are two types of municipal bonds: general obligation and revenue. General Obligation (GO) bonds are issued directly by the government and backed by that government's ability to tax. Revenue munies, on the other hand, are issued by government-sanctioned entities such as the power company and is paid by the revenue brought in by that business (e.g., customers paying their power bills).

    Municipal bonds will generally pay a lower yield than similar corporate bonds, but they can still be a better investment due to their tax-exempt status. As with any other tax-free investment (and we discuss this more in the taxation section of the site), you want to be careful to avoid double-counting if you're holding these in another tax-advantaged account. For example, municipal bonds in a Roth IRA hold no extra benefit as the interest would be non-taxable anyway due to the tax-advantages status of the Roth.

    Another advantage is that municipal bonds tend to be fairly liquid; while you need to hold them to maturity to gain the full benefit, you can be fairly confident of being able to sell them off in an emergency and get back at least the majority of your original investment. Due to the variety of sources issuing bonds, they can also help you to diversify your portfolio.

    Should you buy municipal bonds?  It depends on how well the ones available in your state are paying compared to similarly-rated bonds that are not tax exempt, as well as what investment vehicle you intend to use to hold them (for example, a 401(k) vs a Roth IRA).

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