State, county and city governments across the United States sell municipal bonds to investors. Most municipal bonds are exempt from federal tax and state taxes, if bought in the state of issuance. Because Florida has no income tax, residents can buy municipal bonds issued in other states without having to pay tax.
There are many types of municipal bonds, but the most commonly issued are general obligation and revenue bonds.
Governments sell general obligation bonds to fund immediate needs and pay bondholders back with money raised from taxes. The bonds have no collateral but are backed by the financial strength of the issuing entity.
Revenue bonds are issued by governments to pay for specific projects such as sewage plants. Revenue bonds usually have no recourse, so if the project fails to create income, the bondholders have no claims on the underlying assets.
Short-term municipal bonds have durations of less than three years. Governments usually issue bonds with terms of five, 10 or 30 years. Bonds pay interest monthly, quarterly, semi-annually, annually or at maturity. Municipal bond mutual funds typically pay interest dividends monthly.
Mutual fund companies and brokerage firms send out 1099 tax forms each year. Many bond funds contain small amounts of taxable funds, so shareholders in Florida normally have to report some income when filing their federal taxes.
The lack of a state income tax enables Florida residents to diversify and buy a variety of tax-free bonds from around the nation. Municipal bonds historically have very low default rates when compared with other kinds of investments, and dividing municipal bond holdings across several states reduces the risks to Florida investors.
Many people in Florida invest non-qualified funds into municipal bonds to create tax-free monthly income. Although dividend interest from municipal bonds, or munis, can vary, high-grade bond funds offer fairly steady returns.
When comparing municipal bonds with other types of investments, Florida residents can easily calculate the taxable equivalent that another investment would have to pay to match the return on a municipal bond. If you are in a 28 percent tax bracket you keep 72 percent of your income after tax.
Divide the interest paid on a tax-free bond into 72 percent to determine the tax equivalent yield. For example, someone earning 5 percent tax free with a 28 percent tax bracket would need to make 6.94 percent on a taxable investment to have the same net income.
People with high incomes are subject to the federal alternative minimum tax (AMT). This tax applies to income from municipal bonds as well as other normally tax-free income. The formula for calculating AMT is complicated, and investors should consult tax professionals especially if they earn more than $100,000 per year.
Florida, like any state, can change tax laws at any time, so the tax treatment of municipal bonds could change in the future.