Passive Income With Tax Free Municipal Bonds

Tax Free Municipal Bonds, once almost exclusively the domain of the rich, have gotten a lot more attention from the middle class lately.  As it turns out, you don’t have to be in the top income tax bracket to benefit from municipal bonds.  Investors in the 35% marginal tax bracket are obviously better off with tax free municipal bonds, but investors in the 28% tax bracket are usually better off as well.  And often, depending on the vagaries of the bond markets, investors in the 25% tax bracket can benefit from tax free municipal bonds.

What Are Tax Free Municipal Bonds?

Tax free municipal bonds are issued by towns, counties, school districts, or practically any other local government entity that needs to raise money to fund public improvements.  Just as a corporate bond is backed by the earning power of the issuing corporation, municipal bonds are backed by the taxing authority of the municipality issuing the bond.  While not common, it is possible for government entities to default on their debt.  Therefore, diversification is still an important consideration when investing in tax free municipal bonds.

Characteristics Of Tax Free Municipal Bonds

• No Federal Income Tax – The primary advantage of tax free municipal bonds, of course, is that you won’t owe federal income tax on the interest payments (there is one exception, which I’ll discuss below).
• No State Income Tax – If you buy tax free municipal bonds issued by your state of residence, you probably won’t owe any state income tax in addition to the federal income tax benefit.  There have been a few court cases challenging states’ ability to grant tax-free status to their own municipal bonds while taxing those of other states, but so far the rules have held up.
• Beware The Alternative Minimum Tax (AMT) – Many municipal bond fund invest in so-called Private Activity Bonds, which are bonds issued on behalf of a private user to finance some private project.  An example would be a bond issued by a city to help pay for a private real estate development or factory.  A city might choose to do this to attract some job-creating project that might otherwise be built somewhere else.  Interest on Private Activity Bonds are taxable under the AMT, although they are still tax-free under the regular tax code.  Tax-payers caught in the AMT trap should avoid municipal bond funds with significant private activity bond holdings.  Vanguard’s municipal bond funds intentionally limit AMT exposure, so that’s where I suggest you start.

Buying A Municipal Bond Mutual Fund

Buying a municipal bond fund is much like buying a taxable bond mutual fund.  Attributes to consider include average duration, average maturity, yield to maturity, and credit quality.  As always, lower-quality municipal bonds tend to pay higher rates;  however, they are also at higher risk of default.  For more on selecting a municipal bond fund, check out How To Choose A Bond Mutual Fund.