Tax Free Municipal Bonds

Municipal bonds are generally referred to as tax-exempt bonds due to the fact that they are all exempt from federal taxes. In addition to being exempt from federal taxes, they are sometimes exempt from state and local taxes as well. This is usually only if you are within the state that the bond is being issued in. Municipal bonds that are exempt from federal and state tax are sometimes called “double tax-exempt bonds”; those exempt from federal, state, and local taxes are often referred to as “triple tax-exempt bonds”.

The fact that the interest on municipal bonds is tax-free makes them a great investment option. With many other investments, including bank interest and certificates of deposit (CD’s), the interest earned is taxable. Tax-exempt bonds are particularly beneficial to wealthier parties, and those within the highest tax bracket.

When dealing with large sums of money, taxes add up quick. For example, let�s say an Investor 1 has $1 million in the bank. Investor 1 is getting 5% interest on this sum yearly, for a total of $50,000 in interest earned per year. Investor 2 also has $1 million, but puts it in a municipal bond. Investor 2 is also getting 5% interest yearly for a total of $50,000 in interest per year. The highest tax bracket possible, which both of these investors are assumed to be in, is around 39%.

Example: Calculating Interest in a Tax Free Municipal Bond

Investor 1 has money in a bank: 38% tax on $50,000 interest = $19,000
Total interest earned, after taxes on $1 million = $31,000

Calculations for Investor 2, who kept his/her money in municipal bonds, are quite simple.
Total interest earned = $50,000
Investor 2 never had to pay taxes on his/her earnings from interest.

The Investor that put his/her money in municipal bonds saved $19,000 in taxes. By simply allocating their funds into a smarter investment, they’ve made enough money to buy themselves a new car, make a down payment on another home, or any number of other things that $19,000 can buy.

As you can gather from this brief example, it pays to put your money in municipal bonds for the tax benefits alone. The same interest rate for a municipal bond is a better investment than the same interest rate almost anywhere else across the board.