Municipal Bonds Vs. Taxable Bonds and Certificates of Deposit (CDs): An Overview

Jan 19, 2024 By Triston Martin

In the event that a friend inquires, "Are municipal bonds tax-exempt?" you could be doing your friend harm by responding with a firm "yes" or "no." A person's personal circumstances have a large role in determining the proper response. The magnitude of your tax burden is the most significant of these considerations. Municipal bonds may be a better alternative than taxable bonds if you're in the 35 percent income tax band and reside in a state with high-income tax brackets. Conversely, you may wish to avoid municipal bonds if your earnings fall into the 12 percent tax bracket. This blog gives an overview of Municipal Bonds vs. Taxable Bonds and Certificates of Deposit (CDs).


What Are Municipal Bonds?


When a state, town, or county needs to raise money for capital projects, such as building bridges, roads, or schools, they might launch a municipal bond. Investors provide money to local governments in the form of bonds. People in higher tax brackets find municipal bonds particularly appealing since they are frequently free from national taxes and many state and regional taxes (for residents).


Municipal Bonds: An Overview


Public initiatives such as building schools and hospitals are examples of municipal projects that may be funded via the issuing of a municipal debt obligation (debt commitment imposed by an NGO, private-sector firm, or other public body). Qualified people may earn income from municipal bonds tax-free, although the coupon rates they pay are lower than those on taxable bonds.


Types of Municipal Bonds


Municipal bond


Municipal bonds are classed depending on the basis of the interest expenses & principal repayments that they receive. Many distinct types of bonds exist, each with its own advantages and disadvantages. The interest you earn from municipal bonds may be subject to taxation. If a municipality issues a bond that isn't exempt from federal taxation, the subsequent revenue will be taxed at the federal level.


General Obligation Bond


It's supported by the government, not a particular project, like a toll road; hence it has no intrinsic value. Property taxes may be used to secure certain general obligation (GO) bonds, while general revenues can be used for others. The principle and interest payments of a revenue bond are secured by the issuer or by sales, gasoline, hotel use, or other taxes paid by the general public. The interest & principal payments on municipal bonds are covered by a third party when the municipality acts as a conduit issuer.


What Is a Taxable Bond?



To put it another way, taxable bonds are debt securities (bonds) that are taxed at the municipal, state or federal level. An investor weighing the pros and drawbacks of investing in a taxable or tax-free bond should take into account how much of their revenue they will still have left after taxes.


The Functioning of Taxable Bonds


Most government and business bonds are taxed. Treasury securities, for instance, are subject to federal taxation but may not be charged at the municipal or state level. There are many "taxable" bonds, meaning that the interest paid to investors is taxed at the federal or state level. A bond's interest rate, whether fixed or variable, is a payment made to bondholders in return for their loan of cash to the issuer for a certain period of time. "Coupon payments" are paid yearly, semi-annually, or quarterly based on the bond purchase agreement.


An individual must disclose interest income from taxable bonds in their yearly tax returns to their local, state, and federal governments at the end of the calendar year in their tax files. There are tax consequences for bondholders who purchase bonds at a discount, keep them to maturity, and then redeem them at face value.


Tax Exemption and Municipal Bonds


Bondholders who live in the same state as a municipal bond issuer are free from federal and state taxes on municipal bonds. Certain municipalities issue taxable municipal bonds to fund initiatives that don't benefit the general public. Municipal bond interest for initiatives with no evident public benefit is taxed since the central government won't support them. Investment returns from taxable municipal bonds are equivalent to those of other taxable securities, like commercial and government agency bonds, because the income from these securities is chargeable to the investor's tax.


What Is a CD?



Banks & credit unions offer certificates of deposit (CDs) as a product in return for the customer's agreement to keep a lump-sum deposit intact for a set length of time in return for an interest rate premium. Nearly all customer financial institutions provide certificates of deposit (CDs), even though the terms, interest rate, and fines for premature withdrawal are up to the individual banks, as are the differences between CDs and also the bank's savings & money market services.


The best CD rates can only be found by shopping around since various financial institutions provide a broad variety of interest rates. On the other hand, a digital bank or credit union may pay three or four times as much as the national average on long-term CDs. Special offers with unique lengths like 14 or 20 months, instead of more regular periods based on 3, 6, 18, and full-year increments, provide some of the greatest deals.


Municipal bonds vs. CDs


FDIC-insured CDs may seem like a better choice because of the lack of risk they carry, but this isn't always the case. CDs' inability to keep up with inflation as interest rates drop is one drawback. Because your money will go farther in a deflationary climate, holding on to cash is indeed a better alternative. It's nice to generate curiosity while you're waiting for a CD since that's a positive thing. CDs have typically outperformed municipal bonds by a large margin.


Conclusion


It's important to consider your tax rate, financial objectives, and geographic location before investing in tax-exempt municipal bonds. Domestically issued munis are triple tax-exempt if you reside in a high-tax state, meaning they are exempt from federal, state, and local taxes. A properly-diversified investment portfolio should contain municipal bonds, as well as local and foreign equities, real estate assets, mutual funds, and ETFs.

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