Investor Facts: What Are Municipal Bonds?

When cities and counties need to raise money to build schools or fix roads, they issue debt. That’s a municipal bond.

A municipal bond is not that different from a U.S. government bond. The main difference is who is issuing the debt.

The other difference is that municipal bonds are typically tax-free. Investors won’t owe taxes on income from municipal bonds at the state or federal level.

Municipal bonds also pay out less income compared to taxable bonds from other issuers. However, the lower payout reflects their tax-free nature.

Who needs municipal bonds? Commonly, investors in “munis” are wealthy retirees with high incomes in retirement.

As investors age they sometimes find that their income rises, despite not working.

For instance, they might be forced into taking out required minimum distributions (RMDs) from tax-deferred retirement plans.

Similarly, Social Security is taxed to a certain point. In addition, retirees with money can find themselves paying taxes on dividend income, plus capital gains taxes on stocks they sell.

The income from corporate bonds is taxable, of course, and U.S. Treasury bonds and bills are taxable at the federal level.

The solution for many is to buy municipal bonds.

Lowering risk

It’s tricky to figure out. Online calculators can help investors understand if the return on a given muni bond is competitive after considering taxes.

For instance, assume you have $100,000 to invest and find a municipal bond that pays 5%. How much would a Treasury bond need to pay after taxes to make up the difference?

What about an ordinary corporate bond that is subject to state and federal taxes?

Assume your state tax is 5% and the federal tax rate is 25%. In this example, the Treasury must pay 6.667% to provide the same return. The corporate bond must pay 7.018%.

It might be possible to find a corporate bond that pays north of 7%. But you have to also consider the risk involved.

Corporations can go bankrupt. Bondholders have more rights than stock investors, but even bond holders could be left holding the bag if a company goes under.

States, meanwhile, are much less likely to fail since their income is based on taxpayers and because states must balance budgets every year.

Accordingly, risk in a municipal bond is lower. A corporate bond that pays much more than the 7% target might pay so much to compensate for the risk of a bond failure.

Municipal bonds thus generate steady, relatively safe income for households where any marginal increase in income only adds to the total tax burden.

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