How to Buy Tax-Free Bonds

Bonds are one of the safest investment vehicles. The principal or face value of the bond is paid on a maturity date with interest paid once or twice a year. Municipal bonds, or munis, provide tax-free interest, which makes an attractive investment for people in higher tax brackets. Local governments issue munis to finance operations or build facilities. Follow these steps to buy these tax-free bonds.

Instructions

Difficulty: Moderate

1. Check municipal bond ratings with the Securities Industry and Financial Markets Association. Look for AAA ratings.
2. Ask a financial advisor what tax-free bonds are available in your area. Munis often come in $5000 denominations, but find out about the interest rate and the date of maturity.
3. Know the three types of tax-free municipal bonds and how they are backed. The safest are general obligation bonds backed by the taxing power of the issuing municipality. Designated taxes or revenues from a specific project back revenue bonds, which makes them as safe as the project they support. Industrial development bonds (IDBs) bring in new business to a geographical area by financing the purchase or construction of facilities.
4. Contact a trusted brokerage to buy munis. You can choose to purchase new bonds or trade for existing bonds before they mature. Avoid buying existing bonds unless interest rates have fallen since the bond's issue date.
5. Buy bonds from four or five issues to reduce your risk. This requires a $20,000 investment. A less expensive option is to purchase a unit investment trust or bond mutual fund. Bond mutual funds never mature, however, and you must pay a management fee.
6. Purchase tax-free bonds through online brokerages that offer municipal bonds. Brokerages like Lebenthal & Company send starter kits for first time bond investors. Other online municipal bond providers include First Miami Securities and Stone & Youngberg.

Tips & Warnings

• Calculate whether a tax-free bond is a better option for you than regular bonds. Convert a regular bond's interest rate to an after-tax rate based on your tax bracket. Compare that with the interest rate on the muni. Whichever has the higher interest rate is the better investment option.
• Municipal bonds are only tax-free is purchased in your geographical area. For example, Oklahoma bonds are tax-free for Oklahoma residents, but not Texas residents.
• Defaults on munis do happen on occasion, but are rare. Since 1940, the Public Securities Association estimates that only 0.5% of all munis have defaulted.