Municipal bonds are loans taken by state and local governments and sold to investors. It would be easy to believe that if U.S. Treasury Bonds have virtually no credit risk then certainly municipal bonds have no risk, either. It would be a mistake, however. Many state and local governments are struggling mightily now. New York City almost filed bankruptcy in the 1970s.
Notwithstanding the risks of municipal bonds, they offer some significant advantages. Interest on all municipal bonds issued in the U.S. is not subject to tax at the federal level. Municipal bonds issued within the state where you pay taxes are also tax free in your state. Some states also choose not to tax bonds from other states (in hopes of receiving the same treatment from other states).
Here are some specific tips to help you make wise municipal bond investments.
Mutual Funds
Invest in municipal bonds through mutual funds and ETFs. This will provide two key benefits. The first is that smart people with access to information you lack will be making the actual investments in the bonds. Second, the fund will buy a variety of bonds providing you with some diversification of risk, reducing the probability of your losing money on the investment.
No IRAs
Don't buy municipal bonds (or funds that buy them) in your IRA. Your IRA protects investments from tax. In a traditional IRA, you will ultimately pay tax on all of your investments, even if they would be tax free outside of your IRA. In addition, if you put municipal bonds in your Roth IRA (on which you'll never pay tax) you could, instead, use the money to buy a corporate bond (fund) that would have the same risk but would offer a higher return. Keep your municipal bond investments out of your IRA.
Know Your State
Before investing in municipal bonds, find out if your state taxes municipal bonds from other states and, if so, at what rate. The rate may be small enough that it doesn't matter. For instance, if you have $5,000 invested in municipal bonds yielding 4 percent, you'll earn $200 per year. If that is taxed at 5 percent, your tax for the year on the municipal bonds will be just $10. Of course, if you invest 10 times or 100 times as much, you may be much more concerned about that. Find out before you invest.
Don't Concentrate Too Much
I'm not suggesting that you not think this through carefully - on the contrary, you should. Don't buy bonds or funds that invest in bonds from only one state. States can have economic difficulties that are hard to predict. No one saw Katrina coming more than a few days before it devastated Mississippi and Louisiana. Earthquakes, floods, economic challenges all can have concentrated effects. Spread your risk by investing nationally.
Moderate Income Means Pass on the Munis
If your income is fairly moderate or put another way, if you are not taxed in the highest bracket, you can probably get a higher after-tax return with corporate bonds with comparable risk than you can get from municipal bonds. Would you rather pay 15 percent tax of $45 on $300 of dividends on a corporate bond paying 6% or pay no tax on a municipal bond paying $200 of dividends at 4 percent? You're better off paying $45 in tax and earning $255 rather than just $200.
Municipal bonds can play a key role in your investment strategy if you are fairly affluent, but otherwise they may be a risky way to earn small dividends.
