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Taxable vs. Tax-Exempt Municipal Bonds

Tuesday, Sep 22, 2015

When it comes to tax-exempt muni bonds and taxable municipal bonds, investors tend to have many questions. Why are tax-free municipal bonds more popular? What is the difference between these two types of bonds? Where are they similar?

Municipal Bonds Safety

The municipal bond market is attractive because of the overall low degree of risk. Municipal bonds are issued by government entities like states, cities or counties, which tend to have a lot of power when it comes to raising the necessary funds in order to reliably repay the principal and make regular interest payments. The money invested is used to fund public projects that benefit the community, such as the building of highways, schools, waste treatment plants, parks and hospitals.

Municipalities are thought to be second only to the U.S. government in terms of safety. In fact, according to data compiled by Moody’s Analytics, a leading independent provider of financial research, of all the thousands of municipal bonds that the firm rated from 1970 to 2011, only 71 defaulted. This type of data can put any risk-adverse investor’s mind at ease.

Still, not all municipal bonds are alike. Some carry more risk than others. In fact, the vastness and complexity of the market is one reason why municipal bonds may seem intimidating to individual investors. Depending on factors such as credit rating, maturity, type of issuer, type of bond and geographical location, some municipal bonds are more suitable than others for some investors.

What Is the Difference Between Taxable and Tax-Free Municipal Bonds?

Tax-free municipal bonds interest are not subject to federal taxes (any capital gains are subject to tax), although investors may have to pay state or local taxes. The interest earned on taxable municipal bonds is treated as investment income and is subject to federal, state, and local taxes. Tax-exempt bonds have an obvious tax advantage, but what else sets them apart?

  • Tax-free bonds are used to fund projects that are considered to broadly and significantly benefit the general public, which is why the federal government grants them a tax-free status.

  • Taxable bonds fund projects that benefit a part of society, such as local sports facilities, investor-led housing and underfunded municipal pension plans.

  • Bonds with tax-exempt status tend to provide low yields – the benefit lies in considering the net yield plus the tax benefit.

  • Taxable municipal bonds offer higher yields.

  • Tax-free bonds are more popular and there are many more options available to investors.

  • The taxable market is growing, particularly with the recent addition of Build America Bonds (BABs), which are taxable municipal bonds with federally subsidized borrowing costs for the issuers.

Municipal bonds are highly attractive to investors because they offer a stable source of investment income and often come with a tax-free status. While there are a lot of obvious advantages in choosing these tax-exempt investments, taxable municipal bonds can also be a smart choice, especially when the true tax advantages are considered based on an investor's existing or expected tax bracket.

The GMS Group specializes in demystifying the complex municipal bond market and providing invaluable guidance to investors. To find out more about the advantages of taxable and tax-free municipal bonds or to buy or sell bonds, contact a GMS muni bond specialist today or call 877-567-9811.