The Disadvantages of Tax-Free Bonds

by Karen Farnen
Government-issued bonds sometimes offer tax-free income.

Bond investors lend money to a government or company in return for interest earnings. The investors expect to receive the return of their original investment, known as the principal, when the bonds finally mature. As an additional benefit, the earnings on U.S.Treasury bonds and most federal agency bonds are free from state or local income taxes. Depending on where you live, municipal bonds can be completely tax-free. However, tax-free bonds also have their disadvantages.

Income Taxes

Only municipal bonds from your own state or locality and bonds from a U.S. territory are normally free from all federal, state and local taxes, according to the Financial Industry Regulatory Authority, or FINRA. You usually must pay state income taxes on bonds from any city or state outside your home state. In addition, you must pay federal income taxes on U.S Treasury and federal agency bond interest, although it is normally exempt from state or local income taxes. Interest on bonds in a mutual fund is subject to the same taxes as if you held the bonds directly.

Interest Rate

Tax-free bonds usually pay a lower rate of interest than fully taxable investments such as corporate bonds, according to the U.S. Securities and Exchange Commission. That means that you don't actually receive higher net income unless you are in a high tax bracket. For example, a taxable bond may return 6 percent, while a tax-free bond pays 4 percent. A taxpayer who pays 30 percent in combined state and federal taxes nets 70 percent of the 6 percent interest, or 4.2 percent. This is still higher than the rate for the tax-free bond. If you hold a long-term bond to maturity, market interest rates may rise. In this case, you receive lower returns than you could get by reinvesting elsewhere.

Cashing in Early

You must hold a bond to maturity to receive what you paid for it from the issuer, the face or "par" value. You can sell a bond before maturity to other investors, on the secondary market, but you receive the current market value. If interest rates have fallen, you normally receive less than you paid. This is a type of interest-rate risk. A lack of active buyers may make it difficult to sell at all, creating a liquidity risk.

Callable Bonds

Municipal bonds are sometimes "callable," meaning that the issuer can require you to sell them back before the maturity date. If interest rates fall, the issuer can then return your money and stop paying the agreed-upon rate of interest. Bonds are normally callable only after a specific date. The SEC recommends investigating the call provisions carefully before making a bond investment.

Credit Risk

Tax-free bonds expose you to a possible loss of interest or principal if the issuer defaults. Federal issues such as U.S.Treasury bonds have the full backing of the U.S. government and are among the safest investments, according to Bankrate.com. However, municipal bonds carry a risk of default if the issuer can't meet its obligations; according to the SEC, in 2008 Jefferson County, Alabama, defaulted on $3.8 billion in bonds. A lack of transparency exists in the bond market that can make it difficult for investors to select the safest bonds; for instance, municipal bond investors often do not have access to audited financial statements.

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