The Advantages of Tax-Exempt Bonds

Mark Kennan for  Demand Media writes: When most people think of investing, they often think about the stock market and mutual funds. But, bonds offer an alternative that may better suit you, depending on your financial objectives. When the bonds are issued by federal, state or local governments, they may be classified as tax-exempt bonds, which offer even more benefits.

TAX-FREE INTEREST

The obvious advantage of tax-exempt bonds is that you avoid certain income taxes on the investment income. If you’re investing in federal bonds, you don’t have to pay state or local income taxes on the interest. If you’re investing in state or local bond issues, you get out of paying federal income taxes. Usually, that’s the better way to go if you’re looking for the tax benefits because the federal rates are higher than state income tax rates. For example, if you pay 25 percent in federal taxes and 6 percent in state taxes, you’d much rather get out of the federal taxes if given the choice.

COMPARABLE TAXABLE RETURN

When deciding if the advantage of tax-free interest is worth it, it helps to know the interest rate you would have to earn on a taxable bond to equal your tax-exempt bond return after accounting for taxes. To do so, convert the tax rate you avoid paying to a percentage and subtract it from 1. Then, divide the tax-exempt bond rate by the result to find the interest rate you’d need on a taxable bond. For example, say you fall in the 25 percent tax bracket and your tax-exempt bond pays 4.5 percent. Subtract 0.25 from 1 to get 0.75, then divide 4.5 by 0.75 to find a taxable bond would need to pay 6 percent to offer an equal after-tax return.

FIXED RETURN

Tax-exempt bonds, like other bonds, offer a fixed rate of return so you know what you’re going to get back -- at least as long as the issuer doesn’t default on the bonds. Plus, assuming the issuer doesn’t default, you won’t lose your money. With other securities, like stocks or mutual funds, you can guess at how much you’ll make, but your return isn’t guaranteed. Plus, there’s also the potential that the stock or mutual fund could lose value.

WARNING

If you’re subject to the alternative minimum tax, you might end up having to pay taxes on certain types of municipal bonds that would otherwise be tax-free. Municipal bonds that are issued for private purposes, except for non-profit organizations, become taxable if you’re hit with the AMT. If you might be affected by the AMT, make sure the bond won’t lose its tax-exempt status for purposes of your taxes, because even seemingly public projects, such as housing or airports, can be classified as private-purpose bonds.