Why Your Portfolio Needs Municipal Bond Funds To Shield Your Tax Savings

Municipal bonds are debt securities issued by a local or a state agency. The bonds are to cover the cost of projects like schools and airports. They are exempt from federal income tax, and from state taxes for residents in the state in which they’re issued. This applies for California, Massachusetts, New Jersey, New York, Ohio and Pennsylvania.

Types of bond

There are four main types of bonds: state, national (suitable for those living in states that don’t collect income tax), insured and high-yield. Insured bonds are the most conservative choice, with the insurance making sure the principal and interest is paid if the issuer defaults. High-yield bonds are lower-grade and therefore have their own risks associated.

Are they safe?

Municipal bonds are perceived as safe, particularly as the principal (the money borrowed) and the interest is backed by a government entity. Generally in terms of safety they’re second only to government investments. However, right now several states look to be unsafe, due to underfunding and other issues. If you’re thinking about investing, be sure to look carefully at the fund and what it owns, and look at the fund managers and their own research too. Also, be cautious with the length of bond you choose. All types of bonds can vary in maturity length. Medium length is best, so you gain the benefits of a longer term but without (in theory) being too vulnerable to changes in interest rates.

Taxes

One other consideration is taxes – while portions of the interest accrued can be free from state and local taxes, capital gains tax still applies on profits from buying and selling bonds.