What are Tax-Free Bonds?

Investors are always looking for a means of avoiding capital gains taxes, so "tax free bonds" seem like a very attractive proposition. In reality, they are, but it is not as simple as that. The most common form of tax free bond is the Municipal Bond, and while these are safe investments, they come with their own unique conditions you should understand before making any investments.

Identification

A bond is a security bearing a promise to repay the money loaned under set terms, the most important being interest and duration, at a given date. This date is called the bond's "maturity." Bonds differ from other securities such as stocks, in two ways. A bond holder is a creditor of a company or government, but a stockholder is a part owner. Also, stocks are indefinite. They last until they're sold or the company ceases to exist. A bond exists for a set length of time.

Types

Some bonds are partly or completely tax free. The two major examples of these are US Savings Bonds and Municipal Bonds. The former are different from normal U.S. Treasury Bonds in that they are not traded on bond markets. The latter are issued by U.S. state, county, or municipal governments or government agencies.

Function

Municipal bonds are most often issued for the purpose of raising capital to finance a specific project. For example, your city government could declare that it is issuing 10 year bonds at 3 percent interest to raise money for building a new bridge or library. The standard difference between municipal bonds and other types of bonds, beyond the issuing party, is that the interest, the value gained by the bond, is exempt from federal and local taxation. This is because local authorities exempt the bonds from their taxes in order to attract investment, and the Federal government is barred by law from levying taxing states and cities.

Features

U.S. Savings Bonds are savings tools issued by the U.S. Treasury. Although ordinarily the I and EE Series Bonds are subject to federal income taxes, they are exempted if they are part of an education savings plan. They should not be considered for their tax free status outside of saving for an education.

Considerations

A bond is a reliable, low-risk investment tool, and those that are exempt from taxation offer extra incentive. However, municipal bonds are also typically issued at a lower-than-market standard interest rates, so they often perform roughly the same as similar federal bonds in terms of net yield in the end.