How Are Municipal Bonds Taxed?

Municipal bonds are typically tax-free at the federal level, but you may need to pay taxes at the local or state level.

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Municipal bonds are a popular investment option for many individuals looking to earn steady returns while minimizing tax liabilities. However, understanding how municipal bonds get taxed can be confusing, as the rules can vary depending on various factors.

We will explore the taxation of municipal bonds in detail, covering the basics of what municipal bonds are, the different types of municipal bonds, and how to calculate the tax implications of investing in them.

Key Takeaways

  • Municipal bonds are debt securities issued by state or local governments to help cover expenditures or public projects.
  • Investors favor municipal bonds for their tax advantages, but it’s best to check the tax consequences of specific municipal bonds before investing in them.
  • Tax rules to keep in mind before investing in municipal bonds include the de minimis tax rule and alternative minimum tax.

Overview of Municipal Bonds

Bonds are debt securities companies and governments issue to raise money and cover their expenditures. Municipal bonds, or munis, are issued by state or local governments to fund capital expenditures or public projects such as bridges, schools, airports, highways, and hospitals.

As an investor, buying a municipal bond is essentially like lending money to the government or agency responsible for the project. In return, you will receive regular interest payments over a set timeframe until the bond matures, at which point you get your principal investment back.

One of the most attractive features of municipal bonds is their federal tax-free status. While they may be taxable at state or local income tax levels or under specific circumstances, investors can typically enjoy tax-free interest income at the federal level.

It’s important to note that investing in municipal bonds does involve some level of risk, just like any investment. The creditworthiness of the issuing government or agency can affect the bond’s value, and changes in interest rates can also impact the bond’s price.

Who Issues Municipal Bonds?

Municipal bonds can get issued by several different entities, including state and local governments, school districts, public utilities, and non-profit organizations. While most municipal bonds are tax-exempt at the federal level, some projects may not meet the IRS’s tax exemption requirements. In these cases, taxable bonds may get issued instead, which can offer a higher interest rate.

In response to the economic downturn during the Great Recession, the American Recovery and Reinvestment Act (ARRA) introduced new types of taxable municipal bonds and expanded existing ones, such as Build America Bonds. Unlike traditional tax-exempt municipal bonds, these bonds had a taxable interest for investors. However, through a combination of tax credits and subsidies, the federal government reduced borrowing costs to almost tax-exempt rates. One of the goals was to increase the market for state and local government bonds by attracting investors like pension funds, university endowments, and foreign investors who do not typically pay federal income taxes and do not benefit from tax exemption.

Why Investors Buy Bonds

Most investors buy bonds to generate regular income from the interest payments while preserving their capital in a low-risk investment. While bonds are not entirely risk-free and typically offer lower returns than other securities, they are favored by investors who want to offset the risks of other investments, such as stocks or crypto. I purchased U.S. I-bonds last year to diversify my holdings and balance out some of the riskier assets in my portfolio.

Although munis are typically tax-free, you should verify the tax implications before investing. Investing in bonds issued by an agency of one’s home state often incurs little to no state tax, whereas buying bonds from another state may result in a home state tax on interest income.

Additionally, check the bond’s rating before investing. Bond ratings from Moody’s, S&P Global, or Fitch Ratings can indicate the risk level of a bond based on the issuer’s creditworthiness.

How Municipal Bonds Differ

Before investing in municipal bonds, compare them to other investment options and not solely focus on tax savings. As mentioned earlier, some municipal bonds have state income taxes on the interest payments. If you receive Social Security, the interest you receive counts towards your adjusted gross income, which may increase the amount of taxes you owe. Interest rate risk is also a concern, particularly for longer-term bonds.

Are Municipal Bonds Safe?

For the most part, bonds are a relatively safe investment. However, you should also check the bond’s rating and compare the real return to other similar options before investing. In the case of municipal bonds, you could lose money if the issuer defaults or you get forced to sell the bonds on the secondary market at the wrong time.

Municipal bonds with a rating of AAA are considered the best regardless of their issuer. But, if the bonds get issued by a local government that is on the brink of bankruptcy, such as Detroit in 2013, you could end up losing money.

Municipal Bonds and Capital Gains

If you buy munis on the secondary market, any bonds you purchase at a discount (less than par value) will get taxed at the capital gains rate when you redeem it. However, this tax only applies to the principal and not the coupon (or interest) payments.

You will get taxed a capital gains rate of 15% for the difference between the net present value and the principal payment at security. If that happens, the discount bond ends up costing you more than you’d profit, as shown below:

When considering purchasing munis, don’t rely on just the yield to maturity. Pay attention to the bond’s price to determine the potential tax consequences.

Unfortunately, unlike most investments, bonds purchased at a premium can’t offset capital gains with capital losses. That is because tax-free instruments get treated differently by the Internal Revenue Service (IRS).

Municipal Bonds and the “De Minimis” Tax Rule

One of the more complex concepts related to municipal bonds is the de minimis tax rule. This tax law determines when a discount bond should get taxed as a capital gain rather than ordinary income. According to the de minimis tax rule, if you purchase a bond at a discount, and the discount is equal to or greater than a quarter-point per year until maturity, then you will be taxed on the gains you realize at the redemption of the bond (par value minus purchase price) as ordinary income. This rule applies to munis acquired at a market discount, and it can mean the difference between paying a lower capital gains tax rate and a higher ordinary income tax rate.

To illustrate, let’s consider a bond with a face value of $100 that matures in 10 years. The de minimis “breakpoint” for this bond is $97.50 (100 – [0.25 × 10 years]). If you purchased this bond at a price lower than $97.50, you have to pay ordinary income tax on the discount.

Municipal Bonds and Federal Taxes

Most muni bonds are exempt from federal taxes because the federal government does not tax most activities of states and municipalities. However, there are some exceptions.

For example, muni bonds issued to fund certain activities, like a state’s pension plan obligation, may be subject to federal taxes on coupon payments. Additionally, some munis may become taxable if the IRS determines that the proceeds are used for purposes that do not qualify for tax-exempt status. When this happens, investors may face higher taxes on their coupon payments and receive lower prices if they choose to sell the bond.

Despite these exceptions, taxable munis may still be exempt from state and local taxes, which can result in a better after-tax return for investors in states with high-income taxes compared to other fully taxable fixed-income investments, such as corporate bonds or certificates of deposit. Check with the brokers to determine whether a bond is taxable or tax-exempt.

The Alternative Minimum Tax (AMT)

In the U.S., there are two parallel income tax systems: alternative minimum tax (AMT) and ordinary income tax. The Alternative Minimum Tax (AMT) disallows several deductions allowed in the ordinary income tax code. Taxpayers have to calculate their taxes under each system and pay the higher amount between the two.

Some muni bonds may be subject to AMT if they are used to fund specific projects not backed by a state or municipality’s credit, such as stadiums or airports. If you hold such a bond and are subject to AMT, your interest income will get taxed at the applicable AMT rate, which could significantly reduce your yield.

The 2017 tax law increased the phase-out thresholds for AMT, meaning fewer taxpayers will be subject to it under the new tax laws. As of 2022, the phase-out threshold for married couples filing jointly is $1,079,800. It’s crucial to consult your broker before purchasing a muni bond to determine whether it is subject to AMT.

Zero-Coupon Municipal Bonds

Zero-coupon municipal bonds are purchased at a discount because they do not make interest or coupon payments, and most do not have to be taxed. This makes them a highly advantageous investment, even with lower interest, as long as you invest in a local municipal bond. To determine whether a tax-free bond is better than a taxable bond, apply the Tax Equivalent Yield (TEY) formula.

However, you may be subject to a capital gain or loss if you sell the bond before it matures. If you sell for more than the adjusted issue price, you’ll earn capital gains, but if you sell for less, you suffer a capital loss, which you can then use to reduce your overall tax bill.

The main benefit of zero-coupon bonds is that you buy them at a significant discount to their face value, also known as the original issue discount (OID). For instance, you can buy a $1,000 bond for $500, or most commonly, bonds are sold in denominations of $5,000. The longer the bond has to mature, the bigger the discount.

Additionally, most zero-coupon municipal bonds are rated A or higher by the rating agencies, with an average default rate of 0.08% between 1970 and 2019, according to Moody’s. Nonetheless, it is crucial to check the quality of the issuer before purchasing the bonds.

Keep in mind that this type of bond requires patience. Zero-coupon municipal bonds usually mature between 8 to 20 years, making them ideal for risk-averse investors looking toward retirement.

How to Invest in Tax-Free Municipal Bond Funds

You can buy and sell municipal bonds directly through a brokerage like Fidelity or Charles Schwab or a bank. Alternatively, you can purchase munis from a broker-dealer, an investment advisor, or in a muni mutual fund or exchange-traded fund (ETF).

The Bottom Line

Municipal bonds are an attractive investment due to the tax savings. But, before investing, do some research on the potential tax liabilities, returns, and bond issuers. The last thing you want is to invest in an asset that causes you to lose money.

We are not financial advisors. The content on this website and our YouTube videos are for educational purposes only and merely cite our own personal opinions. In order to make the best financial decision that suits your own needs, you must conduct your own research and seek the advice of a licensed financial advisor if necessary. Know that all investments involve some form of risk and there is no guarantee that you will be successful in making, saving, or investing money; nor is there any guarantee that you won't experience any loss when investing. Always remember to make smart decisions and do your own research!

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