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Home Financial Planning Personal Finance

Tax-Exempt Bonds: What They Are, How They Work and How to Invest

by TheAdviserMagazine
6 months ago
in Personal Finance
Reading Time: 6 mins read
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Tax-Exempt Bonds: What They Are, How They Work and How to Invest
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If you had an investment-related tax bill to pay from 2024, you may be inspired to explore tax-exempt investments moving forward. Below, we’re discussing a few types of bond investments whose interest payments are exempt from federal and/or state income tax, and are available in many brokerage accounts.

Note that the tax exemptions below only apply to the income you would receive by holding bonds to maturity. If you sell a bond before maturity, for a higher price than you paid for it, your profit may still be subject to capital gains tax.

Municipal bonds

States, cities, counties and other local governments sometimes issue municipal bonds, or “munis,” to fund public projects such as school and bridge construction.

Interest is exempt from: Federal income tax, and sometimes state income tax as well, depending on where you live and where the bond is from.

Most states don’t tax their own muni bonds, and several have no state income tax at all. In those cases, muni bond interest is completely tax-free. District of Columbia residents also pay no local income taxes on any muni bonds, and all muni bonds from non-state U.S. territories such as Puerto Rico are state-tax-free in all states.

In some cases, however, interest payments on muni bonds that fund business-like enterprises such as stadiums and airports may be subject to the alternative minimum tax (AMT).

The yields on muni bonds are often higher than the yields on Treasury bonds. But that’s because, unlike the U.S. government, local governments do sometimes default on their debts. The city government of Detroit, for example, defaulted on more than $600 million worth of municipal bonds during its 2013 bankruptcy.

Some muni bonds also have “call risk” (the issuing government may repay the principal of the bond ahead of schedule, causing investors to miss out on some interest payments). Plus, due to their high yields, muni bond prices may fall sharply in response to an increase in interest rates. That’s not an issue if you hold the bonds you buy to maturity, but it’s something to keep in mind.

Available in: Certain brokerage accounts. Some accounts don’t offer individual bonds at all, and others only offer Treasury bonds and corporate bonds. Make sure you research a broker’s investment selections if you’re interested in buying individual muni bonds.

Below is a list of the brokers reviewed by NerdWallet that offer individual muni bonds:

Tax-exempt bond funds

Buying individual muni bonds can be a hassle. One way to simplify the process of adding muni bonds to your portfolio is by investing in a tax-exempt bond fund. These typically invest in muni bonds, and may be available as mutual funds or exchange-traded funds (ETFs).

There are even a few tax-exempt bond funds that invest in munis from a specific state, such as New York, thereby rendering their interest payments exempt from both federal and state taxes for residents of that state.

Interest is exempt from: Federal (and sometimes state) income tax… in theory. Some tax-exempt bond funds advertise themselves as “AMT-free” as well, meaning that they avoid muni bonds that may generate AMT liability.

However, fund managers have a significant amount of discretion over what they invest in, and some tax-exempt bond funds disclaim that they may occasionally invest in assets that do have federal income tax or AMT liability. Make sure you read the fine print before investing.

Funds containing muni bonds deal with the same risks as investors holding individual muni bonds, but a bond fund reduces these risks somewhat for its shareholders by diversifying its investments across many muni bonds.

Available in: Almost all brokerage accounts. Some brokerage accounts don’t offer mutual funds, but tax-exempt bond ETFs can be found wherever ETFs are sold (i.e., in just about any brokerage account).

Treasury bonds, bills and notes

The U.S. government borrows money by issuing Treasury securities of various durations. The term “Treasury bond” is sometimes used to refer specifically to bonds with durations of 20 years or more. Treasury securities with durations of 2 to 10 years are called “notes,” while shorter-duration securities are called “bills.”

The U.S. government is one of the most credible borrowers in the world. It’s not impossible that some cataclysm could cause it to miss payments on Treasuries at some point in the future, but that is so unlikely that it’s generally not worth worrying about.

In recent years, the U.S. government has sometimes had its credit rating downgraded by independent rating agencies, and there have been frequent political fights in Washington over keeping the government funded and raising the debt ceiling. But none of these things have led to a default yet, and the odds of one happening any time in the foreseeable future are still low.

Available in: Most brokerage accounts. Any account that offers individual bonds will offer Treasuries. There is also an emerging product called a Treasury account, which automatically invests — and re-invests — in T-bills. (NerdWallet has a partnership with Atomic Treasury to offer a Treasury account. Public, an online broker we review, also offers a Treasury account.)



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