Personal Finance 101: What Are Municipal Bonds?

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Personal Finance 101Recently, I received a lengthy email from a reader who had a ton of basic personal finance questions contained within. I thought it might be interesting to start an irregular “personal finance 101″ series to answer and explain some of her questions.

In a nutshell, municipal bonds are bonds issued by a city in order to pay for some civic infrastructure, such as buildings or roads. This enables a city to buy these improvements now, but pay for them over a longer period of time.

Why buy a municipal bond? First of all, most municipal bonds are very safe, stable investments. Unless a city or municipality is in desperate financial straits (like Cleveland, Ohio in the late 1970s, for example), municipal bonds are an extremely low-risk investment.

Also, the income earned off of municipal bonds is exempt from federal taxes and, in almost all cases, exempt from state and local taxes as well. In general, the income from municipal bonds goes straight in your pocket.

Wow! So what are the drawbacks? Municipal bonds simply don’t earn as well as many other investments. Short term bonds (less than ten years) usually yield around 3.6 to 3.8%, which seems quite low, especially compared to the fact that you can earn over 5% in a savings account these days. However, that percentage rate is locked in over a long term and there are no taxes to pay on it. If you’re in the 28% tax bracket, you would have to get a 5% to 5.3% return on your money to match it.

Over a long term (up to 30 years), real rates inch up to 4.3% or so, which equates to over 6% if you were buying an investment that required a tax payment.

So, to summarize, municipal bonds are a solid way to earn tax-free income. The rates of return aren’t stellar, but they are good enough to be attractive to people in higher tax brackets.

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5 thoughts on “Personal Finance 101: What Are Municipal Bonds?

  1. Where do you buy these municipal bonds? Do you go to the city hall or through a broker? For example I want to buy municipal bonds from my city, how do I go about doing that?

  2. One *very important* point is that muni bonds are tax exempt only in the state that issued the bond. For example a California muni bond is not exempt for an Oregon taxpayer.

    That leads to a big drawback of municipal bonds. They aren’t easy to buy. Outside of a few states, such as California and New York, the selection is pretty limited.

    Limited selection means less competition and likely higher expenses.

    As an individual investor it’s difficult to buy or sell muni bonds outside of a fund, and if you do buy or sell that way, you will find the market illiquid and therefore fraught with expenses.

  3. Is it correct that if I buy a municipal bond in Colorado that matures in 15 years, and in 15 years I am a resident of another state, like Louisiana, Louisiana will tax me on the interest?

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