Depending on your individual financial goals and risk tolerance, municipal bonds can be a great choice for generating tax-free interest income. You just need to know some of the pros and cons to help determine whether it’s worth pursuing.
What Are Municipal Bonds?
A municipal bond, often referred to as a “muni” bond, is a debt security issued by a state, municipality, county, or other local government entity to raise funds for public projects. These projects can include the construction of schools, highways, water and sewer systems, and other essential infrastructure. The projects can be pretty diverse!
Investors who purchase municipal bonds essentially lend money to the issuing government in exchange for periodic interest payments and the return of the principal amount at the bond’s maturity. This can come with a couple tax advantages.
Municipal Bonds Tax Advantages
One of the primary advantages of municipal bonds is the tax exemption. Investors pay zero federal tax on the investment income, making these bonds a much more attractive option compared to taxable investments. Additionally, income from municipal bonds is not counted as part of your net investment income for tax purposes.
What’s more, if the municipal bond is issued by an authority within the investor’s state of residence, it is typically exempt from state income tax. So depending on where you live, you might get dual tax exemption of both state and federal.
You also get the benefit of having some more stability with municipal bonds. These are typically considered to be relatively low-risk investments, and they can be particularly attractive to conservative investors or retirees. If you like the sound of federal and state tax exemptions and still being able to manage your risks, then these could be a great addition to your portfolio.
Potential Cons with Municipal Bonds
Despite the upsides of municipal bonds, there’s still the possibility of some drawbacks. For example, investing in certain private activity bonds may trigger alternative minimum tax issues. Also, selling a municipal bond at a profit subjects you to capital gains tax. Or you may have bonds from another state incur state tax.
There’s also default risk, which connects to assessing repayment likelihood. In some cases, the interest income from municipal bonds could even render a portion of Social Security benefits taxable. That means you’ll need to make sure to do some careful planning in order to optimize your tax savings.
Time to Schedule a Tax Planning Session?
Connecting with both financial advisors and tax planners can help you design an investment strategy that aligns with your unique needs. You can talk with your financial advisor about the different market trends and opportunities for portfolio diversification, and then meet with your tax planner or CPA to make sure you’re taking the right steps for optimizing tax efficiency.
Understanding your options and tailoring your investment strategy accordingly is key for having a bright future. If you need help along the way, please know that NSO & Company can help! We love helping clients make informed decisions that align with their financial goals. Whether you’re looking for year-end tax planning or ongoing financial guidance throughout the year, our team is here for you!