Tax free bonds
In finance, there are many ways to make an investment. People saving up for kid's college, retirement, etc. need to make a long term investment by which they are not only sure that the money will be there when they need it but the interest has also added up during the period. CDs, stocks and bonds are a few of the investments that one can make. Bonds, unlike stocks with their periodic fluctuations, provide stability and income. There are plenty of other options as well. This article deals with bonds and tax free bonds, their advantages and the problems that an investor can face with bonds.
Types of bonds
A bond can be defined as a debt security. The issuing organization owes a debt to the holders and is obliged to repay the principal as well as the interest at the maturity date. The concept of a bond is that when you buy one, you are lending your money to the company issuing the bond. This is the money that they have to repay at a fixed date. The interest, also known as coupon is paid every six months during the interval. The term " coupon " originated from the small coupons attached to bonds. These coupons had to be sent every six months in order to receive interest. Bonds are normally issued for a period longer than ten years. New debt between one and ten years is termed as a note and the same less than a year is called a bill.
Bonds usually carry a tax on them. There are different types of bonds having different tax structures. Corporate bonds carry no tax - free provisions. Zero coupon bonds are bonds sold at a huge discount and the principal plus interest in paid directly at maturity. U.S.Treasury issues are liable for federal income tax but not for state or local income taxes. Municipal bonds, on the other hand, are free of federal income tax and are free of state and local taxes as well on the condition that it is bought in the state where the buyer lives. Municipal bonds are also known as tax free bonds.
More about tax free bonds
Tax free bond may be defined as tax free mutual fund that invests in municipal bonds. These bonds are issued by many cities all over the United States and are given special tax free status. The only condition is that you must live within the state from which you are buying the bond. For example, if you are living in New York and buy a New York bond, there will be no federal, state or local income tax to pay. These bonds have a lower interest rate than other bonds.
Here the question arises whether one is getting a better income off tax free bonds with a lower interest or off a taxable bond with higher interest rates. Before deciding on purchase, it is imperative to do a few mathematical calculations in order to decide which would be more profitable in the long run.
Tax free or taxable bonds
The trick is to convert the taxable bond's interest rate to its after tax rate and compare it with the tax free bond s interest rate. This will give an idea on which is more profitable. The first step is to figure out your marginal tax rate which is what you pay on the next dollar of income. For eg., if you pay 20% for federal income tax and 10% for state taxes then your marginal tax rate is 20 + 10 = 30%. Subtract this number from 1. After this divide the interest rate of the bond by the result.
In the above example with 30% marginal tax rate and a coupon rate of 8% the calculation can be made as : 0.08/(1 - 0.30). For lower income groups the income is higher than for higher income groups. So tax free bonds are most profitable to people in the higher income bracket.
Stocks and bonds
Having seen in the previous section how to assess the profitability of tax free and regular bonds, there still remains the questions whether bonds are at all good for long term investment. According to some financial experts, stocks are better for long term investment. The problem with stocks is that they are volatile and inconsistent. Bonds, on the other hand, offers safety as well as regular income. If you are able to decide on the right bond for you, after considering the tax and the net profits, then bonds will provide a safe and excellent investment. History shows that stocks have outperformed bonds in the long run. But the element of risk is unavoidable and always exist while dealing with stocks. If your aim is to have a secure investment along with regular income at reasonable rates, bonds are worth your while. If your goal is to earn enormous profits and you are willing to take a risk on your investment, then you are better off with stocks and bonds will not do for you.
Finally, no matter whether bonds fulfil your idea of a good investment or not, it is always better to consider buying one or two bonds that might suit your situation just to give some stability to your investment portfolio.
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