What Are Tax Free Bonds?

What are Tax Free Bonds? Tax free bonds are government issued bonds, often called Treasury notes as they are issued by the US Treasury Department, which pay interest to the bond holder which is not taxed as income by the federal government. In some cases, such as with I Bonds, there is no state income tax to be paid either. At a minimum, all government bonds will not require the holder to pay tax on the interest they receive. For this reason, among others such as confidence in repayment, government bonds have many advantages over corporate bonds. No tax bonds issued by the government should be compared to corporate bonds in a manner which truly reflects their potential for income. Corporate bonds, bonds issued by private companies in order to raise capital, often-times offer seemingly much higher interest or coupon rates. While the interest on their corporate bonds is not a trick, one must consider the interest which will be paid on these bonds when compared to tax free bonds. Government no tax bonds have low interest payouts, but there is more there than meets the eyes. For example if considering the following two bonds, to really compare them one must really see beyond the numbers. These two bonds offer very different interest rates, however the government bond actually pays the investor more:


Corporate bond: 10 years, face value $10,000. Coupon interest rate 10%.

Government bond: 10 years, face value $10,000. Coupon interest rate 4%

While there is an obvious and seemingly attractive interest rate advantage of 6% over the government bond, the corporate bond fails to inform the investor they will pay tax on the entire 10% of interest paid annually, both Federal and State tax considered as income. On average the actual interest will be only 2-3% after included the tax liability.

More Tax Free Bond Advantages

Tax free bonds offer more than just a good and predictable interest rate without tax liability worries: they are also guaranteed by the US Government. Corporate bonds will usually pay a decent return but one should remember just like a stock purchase, there is inherent risk investing in a private entity. A corporation can lose assets, have legal liabilities freezing funds, or simply cease to exist. Government bonds however are all but a guaranteed payback. A very safe investment in turbulent financial times.

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