An investment is considered “triple-tax-free” if it is exempt from taxes at all three levels of government – federal, state and municipal. What kind of investment gives you that sort of a sweet deal? The answer is municipal bonds.
Generally, a state or a municipality offers the bonds with tax-free interest payments to promote investments and further growth in the region, and the non-issuing party (either the municipality or the state) extends tax-free status as a further courtesy – it’s in the best interest of both parties to do so. Typically, you have to live in the issuing area to be able to claim the triple tax advantage.
What about the Feds? They are constitutionally prohibited from taxing the interest from either state or municipal bonds. This set of restrictions and symbiotic relationships give municipal bonds this triple-tax-free distinction.
There are two typical types of municipal bonds that can fall into this category:
- General Obligation Bonds – As the name suggests, these bonds bring in revenue to be used for general funding purposes, and are backed by taxes collected by the issuer. Repayment comes through the typical tax revenue stream, or through any voter-approved bond issues.
- Revenue Bonds – The bonds are issued to cover the costs of a project that will generate revenue when completed – for example, an airport or a toll bridge. Bondholders are paid through the revenue stream of the completed project.
Both types of bonds are typically long term, providing some relatively stable and predictable interest income – thus, you can invest in your local area and receive triple-tax-free status on a predictable income stream. Even so, there are a few mild downsides to consider.
- Low Returns – Because most municipal bonds are extremely low-risk, they also tend to have extremely low returns – frequently below that of Treasury issues. They should fit into the conservative component of your portfolio.
- Callability – If your bonds are callable, they can be redeemed whenever the bond issuer wishes to do so – which may or may not fit in with your financial goals as the bondholder. There is a certain lack of control involved.
Even with these disadvantages, the relative security and tax-free status make them attractive conservative investments for diversification – especially for those in higher tax brackets. Tax-free interest income is nice in the 25% tax bracket, but it is a real money saver when you reside in the 39.6% tax bracket.
Before purchasing triple-tax-free municipal bonds, you should check the bond rating. Moody’s, Standard and Poor’s, and Fitch all perform bond-rating services, so for most bonds, you should be able to receive some feedback. Similar to the way that stocks are rated based on the financial health of a company, municipal bonds are rated based on the overall financial health and creditworthiness of the municipality. The bond services evaluate how likely the issuer is to be able to pay the interest and redeem the bonds.
Should you happen to live in a municipality that has a poor bond rating (a city nearing bankruptcy, for example), to get the triple-tax-credit you may be forced to buy a riskier bond than you would like. The one upside of this is higher risk generally requires higher returns to entice people to buy the bonds. In this case, you would want to place them in the higher risk portion of your portfolio even though they are bonds and not equities.
Consider purchasing municipal triple-tax-free bonds for your investment portfolio, and feel the triple benefit of a steady income stream, tax benefits, and civic pride.