Investment Updates
Tax Pros And Cons Of Municipal Bonds
Published Wednesday, October 29, 2008 at: 7:00 AM EDT
For many investors, an investment in municipal bonds can be a sweet deal. Like other bonds, munis provide regular interest payments. But whereas interest on Treasury and corporate bonds is taxed as regular income, at a rate as high as 39.6% plus the applicable state income tax rate, the income from munis is exempt from federal tax and may also avoid state taxes. The same is true of distributions from a qualified municipal bond fund. And while munis typically offer lower yields than taxable bonds, municipal bonds and bond funds may provide higher after-tax returns to investors in high tax brackets. But munis also come with several drawbacks, and if you’re not careful, your investment in municipal bonds or bond funds could trigger unexpected tax liability.
On the plus side, there are at least four significant tax advantages to investing in munis.
1. First, of course, is that exemption from federal income tax. Suppose you own a $10,000 corporate bond that pays 6% interest, and you’re in the 25% federal income tax bracket. Though you’ll receive $600 in annual income, you’ll lose $150 to the IRS, leaving you with only a 4.5% after-tax return. But with a muni, federal tax isn’t an issue.
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