Investing in municipal bonds can be a benefit due to the fact that the interest income they provide is generally tax-exempt. In order to realize the full tax benefits of municipal bonds, you have to be careful not to make the following mistakes.
Low Interest Rates: Interest income from municipal bonds is usually much lower than corporate bonds, but since municipal bond interest is generally tax-exempt, your returns may be higher when factoring in taxes. The problem arises when you would have received a greater return by investing in corporate bonds than municipal bonds when factoring in taxes. Generally, if you are in a low tax bracket, then municipal bonds may not make sense.
Purchasing Out of State Bonds: Municipal bonds are not subject to either Federal or state taxes if you purchase bonds from your home state. If you live in a high income tax state, such as California, New York, or New Jersey, then you should consider purchasing a bond from your state to reduce the overall tax exemption.
Alternative Minimum Tax: This dreaded tax, also known as the AMT, may make your tax-exempt municipal bonds taxable. If a bond is considered a private activity bond, then you may end up paying taxes on the bond interest.
You must be careful when selecting municipal bonds by doing your research. Otherwise, in your quest for tax-exempt income, you may end up overpaying taxes or unnecessarily receive a low interest rate.