Tax Free Income? Hell yes!

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Most bonds are digital nowadays The best way to earn tax free income is through municipal bond investments. Municipal bonds are bonds issued by-you guessed it- municipalities. Because they generate revenue for localities, dividends-your income- is not taxed by the Feds.

Municipal bond income is also not taxed by the state you live in, so long as you buy the bond from the state you live in. If you buy a Virginia municipal bond and live in the Commonwealth of Virginia you are not going to be taxed at all.

If you live in Virginia and buy, say, a Tennessee municipal bond, you still avoid federal tax but must now pay state tax. So buy munis (municipal bonds) from the state you live in. Or Puerto Rico, which is the only way to remain exempt from state tax if you must buy out of your own state.

I generally prefer municipal bond funds to individual bonds. First they’re easier to buy. There are many fund companies (American Funds, Oppenheimer, etc.)that have funds composed solely of your state’s municipal bonds. Individual bonds you generally must go through a broker, and the best bonds usually get snatched up really quickly by the fund companies and other big fish anyway. Secondly bond funds are easier to sell if you have to sell. You can take a petty big hit selling an individual bond if economic conditions aren’t right when you sell. A fund you can get out of at any time with no problem. Much more liquid.

 Muni funds are great for taxable accounts despite having a low yield. Depending on the rate of taxation you must deal with, your real rate of return, vs. a taxable fund, is usually competitive with less risk. (See my article on calculating yield on tax free funds.)

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