When it comes to finance, stocks are always at the center of everyone’s attention. Lately, cryptocurrency has entered the limelight as well. Both of these securities have strong connotations around them. Stocks and cryptocurrency are famous for their ability to build your wealth and infamously known for making some rich overnight! However, what is not often talked about is the taxes that are paid on stock and cryptocurrency gains. Ah yes, the dreaded capital gains tax always chips away at your returns. In this article, I’ll talk about an investment option that completely avoids federal, state, and local tax. This security that isn’t taxed is called a municipal bond.
Before we get into the municipal bond, let’s review what a bond is exactly. Unlike a stock, a bond has guaranteed return once you purchase it. The main aspects of a bond are the par or face value, the coupon rate, and the maturity date. Here’s a quick summary of what these are:
- Par or face value: The principal value of the bond. Generally, this value is $100 or $1,000, and this value is used when calculating the interest payments.
- Coupon Rate: This is the rate of interest, on the face value, that will be paid to the investor over the life of the bond until maturity. Ie: a 4% coupon rate on a $1,000 bond would mean $40 gets paid to the investor every year.
- Maturity Date: The maturity date is the date on which the bond “expires” or matures, and on this date the investor is paid back the face value of the bond.
Let’s say you buy a bond at par value of $1,000 with a 5% coupon rate and 4 years to maturity. This would mean you would receive $50 every year for four years and at maturity you would be paid back your $1,000. In total, at maturity you would have received $1,200.
Now let’s get into Municipal Bonds. These bonds are special as they are not subject to federal, state, or local taxes (except in some cases). This is important because it means that the gains you get from the interest payments are completely tax-free. Gains from stocks are always taxed either with short term capital gains or long term capital gains. This creates the possibility for municipal bonds to be a safer investment option that can yield an equal return compared to a stock.
Here’s an example:
Let’s say you’ve held the S&P 500 for less than a year then sold. You got the average return of 8%. Since you held it for less than one year, you will be taxed at a short-term capital gains rate dependent on your tax bracket. Let’s say you’re in the 32% bracket. This means that your effective return is really 5.4%. An equal return with a municipal bond would be a municipal bond with a 5.4% return.
All this being said, municipal bonds don’t often offer high yields above 2%. The municipal bonds that do offer a yield higher than this likely have a low credit rating. A bond with a low credit rating is riskier which removes some of the benefit of buying a bond, guaranteed return. The game between risk and reward is a hard balance to maintain. Everyone is different and at different points in their life, so all of those factors should also influence your investment decisions including your decisions on bonds. Overall, stocks often have more risk and reward than bonds do. Municipal bonds are special in that they even the playing field a little bit by removing taxes from the return equation giving some incentive to invest in them. Lastly, always consult a professional and consider your own investment options!