Though usually it's you who pays taxes to the government, owning savings bonds or municipal bonds is an opportunity for the government to be in debt to you. With both types of bonds you are lending money to the government, and you get paid back with interest. Each operates differently but both have tax advantages.
Savings Bond Basics
The U.S. Department of the Treasury issues savings bonds as debt securities to fund the federal government's borrowing needs. Savings bonds are considered very low risk because the American government backs them. They are exempt from state and local taxes, and federal income taxes can be deferred until the bonds are cashed or stop paying interest. Paper bonds can still be purchased through financial institutions or employer payroll deduction plans, but they are also available online directly through the government's TreasuryDirect program.
EE Savings Bonds
Series EE bonds replaced Series E bonds. Electronic EE bonds are sold at face value. Paper EE bonds are purchased at half of their face value. Both are subject to a maximum purchase amount of $5,000 per calendar year. Series EE bonds mature after 30 years, at which time investors receive the full face value plus all the interest that accrued during that time. If redeemed before five years, you forfeit the last three months of interest, but after five years there is no penalty for redemption.
HH and I Savings Bonds
Series HH bonds can only be purchased in exchange for matured Series EE E, or HH bonds, and they mature in 20 years. Series I bonds are sold at face value and mature in 30 years with interest paid based on an inflation index. They are subject to a $5,000 per calendar year purchase maximum and a forfeit of three month's interest if redeemed before five years.
Municipal Bond Basics
Municipal bonds, or muni bonds, are issued by state and local governments. They usually are earmarked for a particular project, like a new school or transportation infrastructure. They make interest payments at regular intervals and have a set maturity date.
Savings bonds can be purchase in small increments, but municipal bonds require a larger investment. While savings bonds are available for as little as $50, muni bonds usually requires a minimum of $5,000. Though defaults are rare, municipals are vulnerable if local governments face economic trouble. Seek muni bonds with a high rating, but remember they are not considered as safe as federal savings bonds. While the value of savings bonds remains stable, the resale value of a muni bond can drop if it is no longer competitive with newer, higher yielding bonds.
Municipal bonds are favored by investors seeking tax shelters because their earnings are exempt from federal income tax. If you buy municipal bonds in your own state of residence, they are also free from state income tax, making them double tax free. They are especially appealing if you're in a high tax bracket. For example, at the 40 percent tax bracket a municipal bond paying 3.35 percent has an equivalent yield of taxable return of nearly 5 percent. Savings bonds have tax advantages, too, but you do eventually pay taxes on their earnings.
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