||Ask Dr. Don
Tax-free municipal bonds
Dear Dr. Don,
Could you please explain what tax-free municipal bonds are?
Municipal bonds are bonds issued by state and local government agencies.
The federal government exempts the interest income from federal
income taxes. The idea behind this is that since the money from
the bond issue is going to fund infrastructure or needed government
services, the federal government supports the state and local government
by making the interest income free of federal taxation.
The tax-free status allows the issuing government
agency to borrow money at a lower interest rate. Investors buy these
tax-free issues because on a tax-equivalent basis the returns are
at or above the interest rate they would earn on a comparable-risk
taxable bond. You can use this tax-equivalent
yield calculator to compare the yield on a municipal bond investment
with the yield on a taxable bond investment.
The federal government encourages state and local
governments to invest in public projects and services. The issuing
agencies benefit by paying lower interest rates, and investors get
tax-free interest income.
In most states, buying municipal bonds issued by government
agencies in your home state will also exempt the interest income
from state taxes. (Sometimes called double tax-free bonds) This
gets municipal investors to invest in bonds issued by government
agencies in their state of residence because the tax-equivalent
yield is even higher.
Illinois, Iowa, Kansas, Oklahoma and Wisconsin have
different standards than the rest of the states about what constitutes
a state tax-free municipal bond.
In metropolitan areas where there is a local income
tax, investing in municipal bonds issued by local government agencies
will provide interest income that is exempt from income taxes on
the federal, state and local levels. New York City municipal bonds
are an example of municipal bonds where city residents can invest
and pay no federal, state or local income taxes on the interest
income. (Triple tax-free bonds)
There are many different types of municipal bonds.
Two key types of municipal bonds are revenue bonds and general obligation
bonds. Revenue bonds are bonds where the principal and interest
payments are funded from project revenues. Construction of a city-
or county-owned parking garage could be financed with a revenue
bond, and the debt service would be paid from the parking fees collected.
General Obligation (G.O.) bonds are bonds backed by
the full faith and taxing power of the issuing agency. A G.O. bond
issued to fund the same parking garage would be considered to have
less risk because the debt-service payments are tied to the tax
base vs. the revenue stream from the parking fees. There are many
variations on the types of municipal bonds issued by government
agencies, but a key point in all issuances is: Does a revenue stream
or the taxing authority of the issuing agency back the bonds?
Many issuing agencies now insure their bonds to guarantee
the repayment of principal on an issue. Like all debt issues, the
riskier the credit the higher the interest rate investors will require
to invest in the bonds. From the issuer's perspective, buying insurance
is less expensive than paying the higher interest rate. From the
investor's perspective, having the insurance is worth the lower
interest rate. When you buy an AAA insured municipal bond, the risk
to you as an investor is minimal.
Municipal bonds have credit ratings just like corporate
bonds. Riskier municipal issues pay higher interest rates because
of the additional risk. If the parking garage is financed with a
revenue bond and the projected revenue doesn't materialize, the
bondholder is at risk. A revenue bond will typically have a reserve
fund that will allow the issue to weather a short-term revenue shortfall.
Investors who are subject to federal or state alternative
minimum taxes (AMT) need to be aware that interest income from municipal
bonds classified as nonqualified private activity bonds may be subject
to the AMT. If you expect to be subject to AMT, you shouldn't invest
in nonqualified private activity bonds.
Your broker or tax adviser can provide you with additional
information, or see IRS
Publication 550, Investment Income and Expenses, for more
about private activity bonds.
-- Posted: Feb. 1, 2002