Why The Phrase, "Tax-Free Municipal Bonds" Is Redundant, And How You Can Benefit Anyway

Posted on: 14 October 2019

People talk about "tax-free municipal bonds" as though municipal bonds are taxable like any other investment. Here is the thing; they are not taxable. Ergo, the addition of "tax-free" to municipal bonds is a redundancy, but maybe it has more to do with the fact that municipalities want more investors who are not in the know. If you are one of those investors who did not know that municipal bonds are (mostly) tax-free, here is what else you need to know and how you can benefit from this kind of investment anyway. 

You Are "Lending" Money to the State Government

A municipal bond exchanges your payment for the bond for a piece of paper that stipulates the amount of the bond, and the expected interest rate on the bond. You can walk into any city or county office in your state, ask about these bonds, and buy as many as you would like or have money for. The state government uses the money you just gave them for infrastructure projects and public construction.

They give you back your money, plus the specified interest, when the bond matures. Because the state is the organization selling you the bonds, they do not tax the interest they give you for lending them money. Because it is a state-issued investment product, the federal government cannot touch the interest or tax it either. It is akin to giving the government money, and they give you free money back for giving them money in the first place. 

The Municipality or Government Can Change the Terms of the Bonds

The downside is that, because you are buying bonds from a municipality, it includes a few quid pro quos. The municipality can "call" the bond at any time, in which case, you might lose the profits you were expecting, lose the interest you were hoping to gain, and/or be forced to buy higher-priced bonds with lower interest. Although this is somewhat atypical, it can and does happen, and the municipalities issuing and "calling" bonds are doing so because something is up with the city's budget, or a project has been canceled or put on hold, and the city finds that it still has to repay the investors who bought these bonds. If you are willing to take that risk anyway, you could make thousands in interest on your investment of tens of thousands of dollars.

For more information, contact a bonds adviser like Alan Z Appelbaum.