Tax free bonds can be a great investment that lowers your tax obligations while still maintaining a fixed passive income.  These bonds generally come in the form of municipal bonds or Treasury bonds.  The tax advantage comes into play on the interest earned.  Which can be exempt from your state, local, or federal income tax.  Making tax free bonds a favorite investment among retirees and individuals in higher tax brackets.

Municipal Bonds

Municipal bonds are bonds issued by states, cities, and counties for funds to build public projects.  That new school, hospital or highway being built in your area is probably funded through a municipal bond.  The local government gets the funding up front which usually gets the project started and finished sooner.

The interest income from tax free municipal bonds is exempt from federal income tax.  Depending on the state you live in, it may also be exempt from state and local taxes, too.  Generally, the higher your tax bracket the more benefit youll get from a tax free municipal bond.  One thing to note, youll get no added tax benefit by holding these bonds in an IRA or retirement plan.  Since the IRA or retirement plan already offers tax exempt status, youre better off looking into taxable municipal or corporate bonds.

Like any investment, there are risks involved with tax free municipal bonds.  The primary one being that the government defaults and wont be able to pay the interest and/or principal.  Inflation risk is always a possibility.  Where inflation may lower the purchasing power of the interest income over time.  Lastly, if you plan on selling the bonds before maturity, there is interest rate risk involved.  Along with the potential capital gains tax if you profit from the sale of the bonds.

U.S. Treasury Bonds

U.S. Treasury bonds are bonds backed by the full faith and credit of the U.S. government.  These bonds are only tax free from state and local income taxes.  All interest income is subject to federal income tax.  If you live in a state with no income tax, youll miss out on any tax benefits.  Even without a tax benefit, these bonds offer the best safety for your money.

Being the safest investment for money, doesnt eliminate all the risks.  U.S. Treasury bonds are still subject to the same risks as municipal bonds.  There are TIPS bonds that have a built in inflation protection.  But interest rate risk and default risk, though small, still exists.

Tax Free Bond Funds

Not interested in owning individual tax free bonds?  There are many tax free bond funds available.  These funds are mutual funds or ETFs that offer the advantage of diversification while still providing tax free interest income.  Because these funds own many bonds, youll miss out on a fixed interest rate and maturity date.  There is also a chance of capital gains tax if you sell your shares.

Each tax free bond fund will have different investment goals.  For instance, one bond fund may only invest in municipal bonds from one state.  Another may only invest in riskier higher interest rate municipal bonds.  Make sure the investment goals of the fund line up with your own goals before committing any money.

If youre looking for another reason to lower your taxes or just add some additional passive income, take advantage of the benefits of tax free bonds.