Recently, 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.