Investing in tax-exempt securities can provide you with a steady income stream without huge risk. Tax-exempt municipal bonds, municipal bond funds and U.S. Treasury bonds make scheduled interest payments that are locked in over the life of the security. You can hold the securities to maturity or sell them to get your principal investment back. Choose a bond or a bond fund that meets your risk tolerance level and your desired investment amount.
When state and local governments need to raise money to fund projects, they issue municipal bonds. If you buy municipal bonds in the same state you live in, the interest is exempt from federal, state and local taxes. The bonds usually pay a lower interest rate than corporate bonds. However, their tax-exempt status makes them a higher-yielding security than corporate bonds. Firms like Moody’s, Standard & Poor’s and Fitch’s rate each bond on the likelihood of the issuing municipality defaulting on their interest and principal payments.
Municipal Bond Funds
Investing in a municipal bond fund lets you reduce the risk of default while still earning tax-exempt income. If a municipality defaults, the loss is spread among the remaining bonds. This has far less impact on your portfolio than if an individual bond you purchased defaults. The interest income is tax-exempt at the federal level but taxable at the state and local levels. You can select a fund that holds bonds issued from different geographic location, a fund that yields a specific interest rate or have a desired credit rating. To maximize your investment, select a bond fund with low management fees, low expense ratios and no up-front fees.
U.S. Savings Bonds
U.S. Savings Bond interest is taxed on the federal level but is tax-exempt at the state and local level. Series EE bonds pay a fixed interest rate that’s compounded semiannually for 20 years. The bonds are issued at face value and the smallest bond denomination is $25. Series I bonds pay a fixed rate of return and have a variable interest rate that’s adjusted semiannually. The bonds are issued at face value starting at $50 and mature in 30 years. Both bond series are backed by the full faith and credit of the U.S. government.
The interest Treasury Inflation-Protected Securities, or TIPS, earns is taxed at the federal level but is tax-exempt at the state and local level. The U.S. Treasury sells TIPS at auction and the interest rate is determined before the auction ends. TIPS’ principal payments are linked to the Consumer Price Index (CPI). The principal payout rises as the CPI increases and decreases as the CPI falls. The smallest TIPS security denomination you can buy is $100. You can choose a TIPS securities that reach maturity in five, 10 or 30 years.
Based in St. Petersburg, Fla., Karen Rogers covers the financial markets for several online publications. She received a bachelor's degree in business administration from the University of South Florida.