These bonds that are tax-free are issued by government-backed entities and are exempted from both federal income tax and state and local taxes. These bonds are used to raise capital for public projects like highways, schools and airports. Investors who seek tax-advantaged income are attracted to these bonds and want a safe investment.
What is the purpose of tax-free bonds?
Tax-free bonds function the same as any other bond except that interest payments are exempted from income taxes in the federal, state and local levels. An investor who purchases a tax-free bond is effectively lending money to the issuer. The issuer promises to repay them with interest over a specific period. At the time of the bond’s issuance, the issuer determines the interest rate (also known as the coupon rate). The investor receives the principal at maturity.
Investing in tax-free bonds has tax benefits
Tax-free bonds offer the primary benefit of exempting interest payments from income taxes. This is true whether they are invested in federal, state or local bonds. Investors in higher tax brackets looking to reduce their tax liability will find tax-free bonds attractive. If an investor falls within the 35% federal tax bracket, and earns 5% on a bond that is taxable, their after-tax yield is 3.25%. Their after-tax yield would be 3.5% if they invested in a tax-free bond yielding 3.5%.
When investing in tax-free bonds, there are some risk factors you should consider.
Tax-free bonds are just like any other investment. Investors need to be aware of the risks before making an investment. Tax-free bonds come with a number of risks.
Interest rate risk – As interest rates rise the value of existing bonds falls. Investors who need to sell their tax-free bonds before maturity may get less than what they paid.
Credit risk – How creditworthy the issuer is can have an impact on the likelihood that repayment will be made. Investors may lose part or all of their investment if the issuer defaults.
Inflation risk – The inflation rate can reduce the purchasing power and return principal at maturity. Conclusion
For those who want to reduce their tax liability, tax-free bonds are a great addition to an investor’s portfolio. Tax-free bonds have risks, which investors should consider before making an investment. Before investing in tax-free bonds, or any other investment product, it is important to research the market and speak with a financial advisor.