Question: What type of investing can an individual do that is exempt from taxes?

Answer: Municipal bonds are an example of an investment where income earned from the bonds is exempt from most taxes. You can purchase an individual municipal bond, or you can purchase shares in a municipal bond mutual fund.

Q: Who issues these types of bonds, and what are they used for?

A: Municipal bonds are issued by states, cities, counties and other government entities. These entities use the funds to help build infrastructure and fund community-based projects such as hospitals, sewer systems, airports, schools or highways.

Q: Are there some investments that are exempt from both federal and state taxes and others that are exempt from just one or the other?

A: When you buy a bond that was issued in the state that you live in, the income that you receive from the bond is generally exempt from federal, state and local taxes. For example, if you are a Hawaii resident and you buy a bond issued by another state, the income would generally be exempt from federal taxes, but it would be subject to Hawaii taxes. Some income may also be subject to the federal alternative minimum tax for certain investors and capital gains taxes.

Q: What are the disadvantages of tax-free investments? What types of risks are involved in these types of investments?

A: Any investment will have its inherent risks. One of the main risks in bonds is credit risk because you are basically loaning money to the issuer, and while it’s rare, there’s always a chance the issuer could default. There is also the risk that interest rates could go up and the value of the bond goes down. There is also time and opportunity risk because bonds are usually a longer-term investment.

Q: What kind of return can an individual expect?

A: Returns vary; however, the returns from municipal bonds could potentially be higher than taxable investments. Income from municipal bonds may be both federal and state tax-exempt whereas U.S. government bond income is subject to federal tax. For example, a 2.5 percent municipal yield may equate close to a 3.5 percent after-tax yield if you are in the higher tax brackets in Hawaii.

Q: How does an individual know whether it’s a quality investment?

A: Bonds receive a rating from private independent rating agencies such as Standard & Poor’s or Moody’s. The rating considers the bond issuer’s financial strength. Bonds rated BBB or better by Standard & Poor’s or Baa by Moody’s are considered investment-grade bonds.

Q: How does a municipal bond mutual fund work?

A: The investment manager of the mutual fund will purchase and manage a portfolio of municipal bonds. As a shareholder of the mutual fund, you would essentially own shares of the underlying portfolio of bonds. All mutual funds have ongoing costs, sometimes referred to as operating expenses, and these costs are usually passed along to the shareholders. When evaluating a mutual fund, an investor should consider the net returns of the fund after fees.