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Federal, state, and local governments pay bond interest that is partly or fully tax free. Munis is a catch-all term for municipal bonds sold by state and local governments. The interest munis pay is generally exempt from federal tax and is usually exempt from state and local taxes for residents of the locality where the bond is issued. If you sell munis for a profit, however, you may owe capital gains tax. And, in some cases, the interest may be subject to the alternative minimum tax (AMT). Municipal bonds, like other investments, have specific advantages but also carry certain risks. If interest rate on newer bonds is higher than the rate on the bonds you own, you might have to sell for less than par value if you sell before maturity. Tax-free bonds that pay the highest interest tend to be issued by governments with low credit ratings. That means the issuers have an increased potential to default. That could mean your losing interest payments or return of principal or both. Financial advisers suggest sticking to highly rated bonds unless you're ready to take this risk. Some mutual funds, including some money market funds, invest only in tax-exempt bonds. That may be an alternative to buying individual munis. Remember, though, that because each fund owns a number of bonds, there's not a fixed interest rate or a maturity date. Nor does a fund promise to return your principal.
Investment earnings on US Treasury securities are free of state and local taxes. But the interest is subject to federal income tax. Treasury bills are available with terms of up to 26 weeks. Treasury notes have terms from two to 10 years, and Treasury bonds have terms of more than 10 years — though the government isn't currently issuing new long-term bonds. The tax on note and bond is due annually, but interest on bills is taxed at maturity, or, if you sell before maturity, in the year the bills are sold.
FIGURING YOUR YIELD
Before buying tax-free bonds, you need to know whether the yield, or what you earn as a percentage of the bond's cost, is better than the after-tax yield on a corporate bond or on another taxable investment. To make that calculation, you have to take federal, state, and local tax rates into account, especially in high-tax states such as California and New York. Tax-free bonds may not offer much advantage if you're in the 10%, 15% or 25% federal tax brackets. But the higher your marginal tax rate is, the more likely you are to receive a greater net yield on a tax-free investment than on one that's taxed. A taxpayer in the 28% bracket, for example, needs a taxable return of about 6.94% to match a tax-free yield of 5%. But if you're in the 35% bracket, you'll need to find a taxable return of 7.69% to equal that 5% tax-free yield. These numbers don't reflect state and local taxes. The taxable return must be even higher if you take those factors into account. Tax Free Investments
These are important and will become increasingly so as your investments earn interest and benefit from capital growth. Each year you will currently pay 20-50% tax on interest earned unless your investment is tax-free. In addition, where you have sold investments which have seen capital growth i.e. shares, funds, investment trusts, second homes you will have to pay capital gains tax where your gains exceed £10,600 during 2012/13 tax year, unless they are in a tax-free investment or are...