I remember about 15 years ago when I first starting studying to take the Stock brokers General License exam. It was pretty intense, it is a 6 hour exam, that you have to take blindfolded with one arm tied behind your back, with no computer, pen or paper in front of you. No I am just kidding, everything after 6 hour exam is not true, but it sure felt like it at the time. It was one of the most difficult exams I had ever taken in my life at the time. Stocks or equities, which is considered ownership in a company and Bonds, which is debt that one can purchase in exchange for payments, made up most of the 6 hour exam.
To keep this blog very simple and at a high level, Bonds come in primarily two flavors, General Obligation (GO) and Revenue Bonds. Let’s do a quick review of both so we can find out if Tax Free Bonds really are Tax Free. To accelerate this explanation, anything to do with Revenue will not be Tax Free so that means that Tax Free will more than likely be on the General Obligation side, so I will finish up there last. That means a super quick overview of Revenue Bonds. We have already established the fact that Bonds overall is debt or in fancy financial terms debt instruments. Most public companies such as AT&T, Target, Amazon, and Nike may at times need to raise capital or money to finance a project or grow a division of the company. They may not want to issue any more stock or ownership in the company so they go to the public and ask for a loan. You and I look at what they are offering in their loan package, and decide if we want to loan them our money for 10 or 15 years in exchange for interest payments usually paid out every quarter. This also means you would naturally get your money back at the end of the same period they needed it for. So if it’s 10 years then over that period you would get interest payments and then get your original capital back.
This would be considered a Corporate Bond and the payments would be made out of the company revenue. Because it is corporate and you really only have the full faith of the strength of the company, and they generally would pay out a higher percentage of interest. Sometimes unusually really high, to attract buyers with hopes of building out their project, which would increase revenue and in turn raising the value of the overall company. There you have it, Revenue bonds most found with Public and in some instances private corporations.
Now let’s address the 3,000 pound elephant in the room, Tax free bonds. I want to tell you something up front before you read any further, they are in fact tax free. So you can stop reading this blog at this point, UNLESS. Okay what does that mean, in short General Obligation bonds, which are considered to be the safest type of bond you can buy, because of that reason. (GO) bonds are considered safer and in turn pay out less on interest because they are backed by a general obligation, and all intensive purposes we will call this obligation, taxes. Taxes, backed by law have a way of being safe to the person receiving the payment on the other end. If someone told you they would repay you back all of your original deposit or loaned amount with interest and they would guarantee it with the taxes of everyday taxpayers then you would take that deal. Now if it is a municipality, or in short (muni) bond that issued the bond then it is more than likely free of taxes. There are muni bonds at the federal level and bonds at the state level. If you live in the same state of the issuer then there are no federal or state taxes associated with the bonds. If you purchase them at the federal level then no federal taxes, well UNLESS.
Okay let’s wrap this blog up with the following statement. Tax free bonds are in deed tax free, unless you are receiving Social Security Benefits, see I said it. Yeah, what a surprise, because I have gone half my life or half my financial practicing adult life thinking Tax Free Bonds were in deed tax free. Let’s set the record straight again. They are! UNLESS you are receiving Social Security Benefits. On the My Retirement Exit Podcast I think I shared this along with another great surprise at age 70 ½, Episode 4, I think I shared about how you may want to set your retirement buckets up differently to make sure you do not get caught holding a tax bag you can’t afford when you are retired. The reason why it is not tax free when you are retired is because when you take money from the government you have to now play by their rules. Receiving Social Security you fall under what is called Provisional Income. In short it is calculated by adding up all of your gross income, ALL TAX-FREE interest, and 50% of your Social Security Benefits. So are Tax Free Bonds really Tax Free, Yes Unless. Helping people get to their retirement is what we do, helping people win, when it seems like they are losing is our foundation, so until next time.