A municipal bond is a type of debt security issued by a state, county, or other local government. Municipal bonds – sometimes abbreviated to ‘muni bonds’ – are issued to finance capital expenditures in the jurisdiction in which they are issued.
Municipal bonds are classified according to the purpose of their issue.
General obligation bonds are issued to raise capital for general purposes and are not supported by revenue from a specific source, such as a toll road or income from sewer services.
Revenue bonds are backed by proceeds from a specific revenue source. This is commonly revenue from sales or occupancy taxes.
Municipal bonds are attractive to many investors due to their relative security of principal and tax advantages.
Municipal Bond Taxation
Interest income from municipal bonds is exempt from income tax at the federal level. State and local governments may tax municipal bonds interest, but many choose not to. This makes municipal bonds especially attractive to investors in high income tax brackets.
When comparing municipal and corporate bonds, investors can determine whether or not the tax benefit of a municipal bond is beneficial to them by using a calculation known as the tax-equivalent yield.
This is done by dividing the municipal bond’s yield by the number 1 minus the investor’s tax rate percentage. The resulting number is the equivalent corporate yield.
Between the municipal bond’s yield and the equivalent corporate yield, whichever number is higher represents the bond that will yield the highest.
Conversely, replacing the municipal yield with the corporate yield in that calculation will result in the equivalent municipal yield.
Municipal Bonds in Retirement Planning
Municipal bonds are very popular tools for retirement planning, especially among those in higher income tax brackets. The benefits of these bonds only come through if they are held in taxable accounts, though. Most experts advise against holding municipal bonds in individual retirement accounts (IRAs).
This is for two reasons: firstly, an IRA already offers tax deferral, so holding municipal bonds in these accounts gives no additional tax benefit. Secondly, withdrawals from an IRA are fully taxable, regardless of the type of investments in the account – that includes investments that would otherwise be tax-free.
For many investors, municipal bonds are a great retirement planning tool. If you decide to go this route, be sure you are doing it for the right reasons and are using the most appropriate account type.
Municipal Bond Risks and Comparison to Other Bonds
In general, municipal bonds considered high-quality debt securities and have a low risk of default. They are not quite considered to be quite as low-risk as U.S. Treasury bonds – which are backed by the full faith and credit of the U.S. government – but they have a lower risk of default than corporate bonds.
Among municipal bonds, general obligation bonds are usually considered more secure. This is because the issuer can use its general funds for interest and principal payments. Revenue bonds are dependent on their specific project, so bond investors are on the hook if the project fails.