How To Invest in Tax-Free Municipal Bonds, and Whether You Should

Tax is a problem for many people. The IRS knows nobody wants to pay taxes and can hit you with severe penalties if you miss a tax deadline. Investing in tax-free municipal bonds is a great way to minimize your tax burden without running afoul of the IRS.

Billionaire Warren Buffett isn’t a big fan of bonds. Instead, the "Oracle of Omaha" recommends putting money into an index fund. But bonds can help you build a more diversified and resilient investment portfolio, and municipal bonds can offer you a major tax advantage.

When they are short of money, states, cities, and local governments can borrow to fund infrastructure projects such as building roads and hospitals. Municipal bonds, or muni bonds, are debt securities issued by municipalities. The interest paid on these debt securities is usually exempt from federal income taxes (hence the name tax-free municipal bonds). Like corporate bonds or others, municipal bonds can mature in one year or 30 years.

Tax-exempt municipal bonds come in a variety of forms. The most common type of muni bond is the GO (general obligation) bond. A GO bond is backed by a municipality’s full taxing power, meaning the issuing entity can tap revenue from various sources to meet bond obligations such as interest payments and principal refunds.

The other type of muni bond is the revenue bond. This type of bond is backed by revenue expected from the specific project being funded by the debt. Therefore, GO bonds are more secure than revenue bonds but offer a lower yield.

You can enjoy a triple tax-free advantage with municipal bonds. In addition to avoiding the federal tax bill on interest payments, you may also be exempt from state and local taxes if you live in the state or locality that issued the bond. Muni bonds usually pay interests semiannually and can be an important additional income source in retirement. At their maturity, you’ll receive your principal back. Another advantage of municipal bonds is that they're generally safe—the risk of default is negligible.

Despite their tax advantage, muni bonds offer lower interest rates than comparable corporate bonds. Additionally, they can be recalled before maturity. This usually happens when interest rates drop significantly. In such cases, the municipality may retire the existing bonds prematurely and borrow anew at a lower rate. When that happens, you'll get back your principal but the interest payments would cease.

Those enjoying Social Security benefits in retirement should also approach municipal bond investing carefully. Although you won’t have to pay federal taxes on interest and may escape state and local taxes, the earnings from the bonds could drive up your adjusted gross income and increase your tax bill.

Tax-exempt municipal bonds may appeal to some. Similar to stocks, muni bonds can be invested in through various ways. You can purchase and hold the bonds directly with an online brokerage account.

Alternatively, you can buy shares in a mutual fund or ETF that invests in municipal bonds. Investing through a fund can give you more diversified exposure to muni bonds, but it's worth noting that many funds carry an annual fee (an expense ratio) that can reduce your returns.