If you’re looking for a stable investment that earns a tax-free return, consider investing in tax-exempt bonds.
Tax-exempt bonds are financial instruments that help local governments borrow money. For instance, if Austin, Texas, needs cash to build new environmentally friendly water plants, it can borrow from individual investors by selling bonds. The investors lend their money to the city, and in exchange, the city agrees to pay the loan back with interest. It’s a win-win situation. Austin gets new utilities, and investors get a low-risk return on their investment.
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Local governments, like the one in Austin, get a helping hand from the federal government. Because Congress wants to encourage private investment in local government projects, the interest payments that investors receive from most local government borrowing is not taxed. Although it must be reported on your Form 1040, tax-exempt bond interest is not included in your taxable income—hence the name, “tax-exempt bonds.”
There is an additional perk. Most tax-exempt bond interest escapes not only the ordinary income tax but the alternative minimum tax as well.
Of course, not all bonds are tax-exempt. Interest on federal bonds, like the popular Series EE and Series I savings bonds, is fully taxable. In addition, corporate bonds, like those issued by Ford (Stock Quote: F) or General Electric (Stock Quote: GE) don’t directly benefit the general public, so investors who buy them receive no special treatment. Likewise, if a local government issues bonds and uses the money for a non-public purpose, interest that investors receive from the bonds will be taxable. How can you tell the difference? Your investment advisor or online service will tell you which bonds are tax-exempt, which ones are not, and which ones must be counted for the alternative minimum tax.
So, Are Tax-Exempt Bonds a Good Investment for You?
When deciding whether to invest in state or local bonds, you should consider a number of things. First, do you really need a tax exemption? If you are investing inside of a tax-free account, like an IRA or a health savings account, buying tax-exempt bonds doesn’t make sense. Because of the savings that they offer, tax-exempt bonds usually pay less interest than taxable ones.
