Tax saving with Municipal Bonds

Municipal bonds are debt obligations of states, cities, and other public subdivisions. Most, but not all, of them pay interest that is exempt from federal income taxes. This interest is also often exempt from state and local taxes. A small proportion pays taxable interest or interest that is subject to the alternative minimum tax (AMT). Municipal bonds can be purchased through nearly any brokerage company. Investment companies that hold portfolios of municipal funds can also enjoy the tax-exempt income that they provide.

In one sense, tax free munis are more complicated than tax free Federal obligations, since the Federal debt is free from all but Federal tax, while the munis are usually only free from local taxes if you live in that locality. That's why when you look at tax free muni funds, you'll see them listed by state, like "Massachusetts Tax Free" or "California Tax Free." If you don't live in that state, they will be Federal tax free, but you'll still have to pay state, and maybe even city tax. Municipal bonds aren't 100% safe, cities have been known to default from time to time, but there are rating agencies to tell you if the credit isn't top notch, and muni funds that spread the risk around in your state to the point where you shouldn't have to worry about it.

Example
David owns a $50,000 municipal bond that he bought at face value less than a year ago. The bond has a 3% coupon rate. Because of rising interest rates, the bond is currently selling at 95, or $47,500. If David sells the bond in 2006, he will recognize a $2,500 capital loss. He can then invest the $47,500 of proceeds in a new municipal bond paying interest at 4%. David’s effective tax rate is 33%. If David were to do this it would enable him to currently benefit from the $2,500 decline in the bond’s value. He has a short term capital loss, which is a tax savings of $825 ($2,500 X 33%) against his ordinary income. Although David would then have bonds that will pay $2,500 less at maturity, he may more than offset this with the increase in current municipal bond income ($1,800 per year with the new bond versus $1,500 per year with the old bond) and the current tax savings from the capital loss.