Bonds are debt instruments. Bondholders receive income from these investments in the form of interest payments. Generally, you must pay income tax on most types of interest, including bond interest payments. However, under federal tax rules, the Internal Revenue Service does not assess income tax on the interest paid by many types of municipal bonds. Interest from most other bonds, such as federal bonds, corporate bonds and mortgage bonds, is fully taxable. Both taxable and tax-exempt bonds offer investors numerous benefits as well as a few drawbacks.
Because income tax is not assessed on municipal bond interest, the bond issuers typically offer lower yields than for taxable bonds; and because interest from corporate bonds and mortgage-backed securities is taxable, these bonds usually offer higher yields. One variable, however, is that credit agencies rate bond offerings based on the risk of the borrower’s default. Municipalities with high debt levels and minimal income are more likely to default than entities with low debt and high revenues; thus, high yields on bonds are indicative of higher risk. Tax-exempt municipal bonds with higher yields than taxable bonds are higher risk, and this risk factor should not be overlooked when planning an investment strategy.
Tax-exempt income sounds appealing, but if you fall into the lowest tax bracket, you may realize little or no benefit from investing in tax-exempt bonds. You might earn more interest investing in taxable bonds because you'll pay little or no income tax. The more money you make, the more you could save on taxes by investing in municipal bonds. The tax savings are even greater if you live in a state that levies personal income tax, because you pay no state tax on bonds issued by government entities within your state. If you live in a state with no income tax and you pay very little federal income tax, a higher-yield taxable bond may be a better choice.
General obligation tax-exempt bonds are backed by tax dollars, which means that the entity issuing the bond can raise taxes to cover any shortfall that could put bondholders at risk. By comparison, a failing corporation cannot raise tax to cover a shortfall; similarly, a mortgage bond loses all value if the borrowers default on the underlying mortgage tied to the bond. However, some tax-exempt bonds fund projects such as toll roads, and you could lose your money if the project tied to the bond goes bankrupt. Furthermore, while municipalities can raise taxes to cover tax-exempt bond payments, the federal government can do the same to cover obligations on its own taxable bonds. Therefore, different types of tax-exempt and taxable bonds expose you to varying levels of default risk.
Aside from having to contend with default risk, bondholders must also consider other risks, such as inflation. If inflation rises, people who rely on fixed income payments have less spending power because their income does not keep pace with inflation. Because municipal bonds typically offer lower yields than taxable bonds, the effects of inflation tend to impact tax-exempt bondholders more than other investors. Federal government bonds usually have even lower yields than municipal bonds. When inflation looms, you can invest in federally issued Treasury Inflation Protected Securities, or TIPS, which fluctuate with rising inflation.
When taxes rise, yields drop on newly issued municipal bonds because investors rush to buy these bonds, allowing issuers to sell the bonds at lower interest rates. Conversely, yields must rise on taxable bonds so that tax increases won't eat up an investor's returns. After a round of tax increases, investors who own older, high-yield municipal bonds can often sell those bonds at a premium. However, before you decide to sell your bonds at a premium, weigh the tax consequences. You pay no income tax on tax-exempt bond interest payments, but you do pay tax on capital gains when you sell your bonds. This means the tax consequences of selling your bonds may outweigh the benefits.
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