Though risky, buying municipal bonds may be a great option for those looking to earn money on an investment without paying taxes on it. YNN's Tara Lynn Wagner filed the following "Money Matters" report.
If you are looking for a relatively safe investment with a secured rate of return, you might consider municipal bonds.
"Municipal bonds, tax exempt bonds, munis, basically are bonds issued by states and local governments for public purposes," says Vice President Branch Manager of Charles Schwab Doug Zarookian.
Buying a bond means essentially lending that municipality money - say, for example, $1,000.
"In return for that, they are promising to make you a steady payment of income, usually received semi-annually as a dividend payment, and in addition to that, they make the promise that at some certain point in the future, they will return your capital to you, the so-called 'maturity date' of the bond," says Zarookian.
The interest on a municipal bond is set at a fixed rate, or coupon, so you know exactly how much you'll be earning. Even better, those earnings may be tax free.
"You'll never pay any federal tax on those bonds," says President of Wealthstream Advisors Michael Goodman. "Whether you pay state income tax will depend on whether you lent money to your municipality or another. If you lend money to a municipality which you pay tax in, you won't pay tax on the earnings either."
Steady tax-free income and getting your initial investment back? Sounds like a win-win.
"Most bonds will pay out the principal the long run," says Goodman. "Stocks can decline in value and never come back."
However, while bonds are considered safer and less volatile than stocks, there are risks involved.
For one thing, the municipality could go bankrupt, which while rare, does happen.
To hedge your bet, consider investing in a municipal bonds mutual fund rather than individual bonds.
"With $1,000, you don't own one bond, you own probably hundreds of bonds, and therefore you can diversify your risk greatly," says Goodman.
The other risk comes at resale. Interest rates will eventually rise, which as Goodman explains, poses a danger.
"The value of your bond will decline," says Goodman. "That's because I can go out now today and buy a bond at a higher prevailing rate so I don't want your bond."
Since you'll only lose money if you sell, the best option is to hold on to what you've got.
"If you're able to hold onto that bond until it matures, you will get your capital bank," says Zarookian.