Using Municipal Bonds To Earn Yourself Tax-Free Passive Income
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Passive income is money that you can make without doing any work. When you buy stocks, passive income is earned in the form of a dividend and that income is usually taxed at 15% as a long-term capital gain. When you buy a municipal bond, the dividend or interest payment you receive from the bond is free from federal and state taxes. In this post I’m going to discuss the following:
- What are bonds and what are municipal bonds?
- Why would you want to buy municipal bonds?
- How can I purchase municipal bonds?
What are bonds and what are municipal bonds?
A bond basically represents a loan made by an investor to a borrower. For example, when you buy a house or a car by taking out a bank loan, you need to pay back the loan amount plus some additional interest every month. Think of a bond as a loan. When you buy a bond you are lending someone else your money, and they agree to pay you back with interest.
Municipal bonds are specifically sold by local governments. When you buy a municipal bond, you’re lending money to a city to fund various projects that can range from building a new park, or updating a bridge. In return for lending your money to the local government, the interest payments you receive will be exempt from both state and federal taxes.
Why would you want to buy municipal bonds?
If you’re looking for passive income and want to avoid paying taxes, the tax-free interest payments from municipal bonds are highly attractive. For example, let’s look at your dividend return from investing $10000 in Verizon (VZ), which has a pretty high dividend yield of 4.46% versus $10000 OPCAX, a California Municipal Bond fund that has a yield of 3%.
In California, all capital gains regardless of whether it’s long-term or short-term will be taxed as regular income based on your income bracket and filing status. In this example, let’s assume you make over $60,000 per year, but under $295,000 per year. Your State Tax on dividends would be 9.3%.
| Dividend Return | Federal Long Term Capital Gain Tax (15%) | California Long Term Capital Gains Tax (9.3%) | Total Taxes Paid | Return After Taxes | |
| Verizon | $446 | $67 | $41 | $108 | $338 |
| OPCAX | $300 | $0 | $0 | $0 | $300 |
Although you still net more by investing in dividends that are taxed, municipal bonds may still be an ideal option if you want to avoid paying taxes on your returns.
How can I purchase Municipal Bonds?
You and I can’t purchase municipal bonds directly from the state treasury. We usually have to buy them in the secondary market, typically through a brokerage account such as Fidelity, TDAmeritrade, or Schwab.
Another option is to purchase them through a mutual fund or ETF. Certain mutual funds will contain a mix of different bonds issued by a state to help diversify your bonds. For example, if living in California, you can purchase shares of OPCAX, VCITX, or NCHAX which will provide you exposure to many Long Term California Municipal Bonds.
Based on your age, however, you may not want to be heavily invested in bonds. A safe ratio for young investors is 80:20 – where 80% of your savings are invested in securities (stocks, mutual funds, and ETFs of stocks) and 20% is invested in bonds.