A municipal bond is a promissory note issued by cities, states or other regional governmental units, such as counties. Municipal bonds generate money to build schools, public works projects and other facilities for the common good. The interest paid on municipal bonds is federally tax-free and also state tax-free if you are a resident of the issuing state. Cashing in a municipal bond carries no specific penalty, but it may carry some financial costs.
While not as liquid as the stock market, there is an active market where you can buy and sell individual municipal bonds. As with the stock market, you can offer to sell your bond at a specific price, or you can just sell it at whatever price an available buyer will pay. Municipal bonds do not carry early redemption penalties like certificates of deposit often do because you are selling the bond to another investor rather than back to the issuer. However, the broker you use to enter the trade will usually charge a fee or commission. These costs can usually run from between 1/2 to 1 percent, although individual brokers may charge more or less.
Loss of Interest
Most municipal bonds pay interest twice per year. When you cash in your municipal bond, the buyer pays you the interest you are due from your last pay date until the date of sale. However, you lose all right to future payments from that bond. If you were relying on the next payment, you'll have to readjust your planning to compensate for the lack of income.
Loss of Principal
The price of a municipal bond will fluctuate with the rising and falling of market interest rates. If interest rates go higher, bond prices go lower. If you sell your bond before maturity, or the date when the issuer promises to pay back the face value of the bond, you run the risk of receiving less than you paid for the bond. The penalty for selling early could be the loss of principal that you would otherwise recoup at maturity.
Capital Gains Tax
If interest rates fall and the price of your bond rises, you will be responsible for capital gains tax if you sell the bond before maturity. For example, if you bought the bond for $950 and you sell it for $1,020, you will owe tax on the $70 of gain on your bond, even though it is a tax-free municipal bond. You can usually avoid this tax if you buy bonds at an original issue discount and hold the bond to maturity.
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