How Are Municipal Bonds Taxed?

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How Are Municipal Bonds Taxed?
BondRequired Rate of ReturnCoupon RateCash Flow at End of Year 1 (Coupon)Cash Flow at End of Year 2 (Coupon + Principal – Tax)Net Present Value
Cap. Gains Tax (15%)4%2%$2$101.34$95.62
Ordinary Income Tax (37%)4%2%$2$100.38 (Tax = $100 – $95.62 x 0.37)$94.73

While an investor may pay $95.62 if just capital gains tax is deducted, the real value is substantially lower—only $94.73. The buyer must determine if the bond is subject to de minimis at the time of purchase since the after-tax return might be much lower than anticipated.

Municipal Bonds and Federal Taxes

Because the federal government does not tax most state and local operations, most muni bonds are tax-exempt. However, certain activities are not excluded from this fee. Coupon payments on muni bonds sold to support such activities, for example, are federally taxed; a classic example is a bond issued to cover a state’s pension plan obligation. When this form of bond is for sale, the broker selling the bond should be able to tell whether it is taxable or not.

When assessing how much of a Social Security payment is taxable, the IRS considers municipal bond income in the modified adjusted gross income (MAGI).

Another frightening example of taxable munis are those that are initially tax-free but subsequently become taxable if the IRS thinks the revenues are being utilized for non-exempt reasons. This is very unusual, but when it does occur, it leaves many disappointed investors; their coupon payments are taxed as regular income, and if they want to sell the bond, the price they get will be decreased since purchasers would need a greater return on a taxable bond.

Taxable munis are still generally exempt from state and local taxes, so investors in states with high income taxes may find that taxable munis provide a better after-tax return than other fixed-income investments that are fully taxable at all levels, such as corporate bonds or certificates of deposit.

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The Alternative Minimum Tax

Although it is unusual, certain municipal bonds are susceptible to federal taxation if the holder is subject to alternative minimum tax (AMT).Before purchasing a muni, check with your broker to see whether it is subject to AMT.

A bond for a specific municipal development, for example, that is not guaranteed by the credit of a state or municipality but rather that of a company (such as an airline financing an airport improvement bond), would be subject to AMT.

Zero-Coupon Municipal Bonds

Zero-coupon municipal bonds, which are purchased at a discount because they do not pay interest or coupons, are not taxed. In truth, the majority aren’t. Taxes will not be an issue if you invest in a local municipal bond. Even with reduced interest rates, this gives a significant benefit over taxable bonds. Simply use the Tax Equivalent Yield (TEY) method to see whether a tax-free bond is a better investment than a taxable bond.

Another thing to keep in mind is that if you sell the bond before it matures, you will almost certainly incur a capital gain or loss. If you sell for more than the adjusted issue price, you will record a capital gain. If you sell for less than the adjusted issue price, you will have a capital loss, which you may use to lower your total tax payment.

The most apparent advantage of zero-coupon bonds is that you are purchasing the bond at a significant discount to its face value. This is sometimes referred to as the original issue discount (OID). A $1,000 bond, for example, may be purchased for $500. However, most zero-coupon municipal bonds are marketed in $5,000 denominations. In any case, you’re getting a great deal. This permits you to purchase additional bonds if you so wish. The greater the maturity date of the bond, the greater the discount you will obtain.

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Of course, you must keep your part of the contract in order to get the most rewards. This just implies you must be patient until the bond matures. You will get a big return that is also tax-free if you do so. And, if you dislike guessing or worrying about economic circumstances, a zero-coupon municipal bond is worth considering since you will get a single payment at maturity based on the principle invested plus the interest generated (compounded semi-annually) at a fixed yield.

The majority of zero-coupon municipal bonds expire between eight and twenty years. If you’re a risk-averse investor planning for retirement, it’s strongly suggested that you talk to your financial adviser about zero-coupon municipal bonds.

$3.9 trillion

The municipal market size in the United States.

According to an annual analysis by Moody’s rating agency, municipal bonds are one of the safest investments available, with an average default rate of 0.08% between 1970 and 2019. Although most zero-coupon municipal bonds are rated A or better by rating agencies, it is still vital to examine the issuer’s quality. If you’re unsure if you made the right choice, you may put your mind at rest by obtaining bond insurance.

Muni Bond Taxes FAQs

What Is the Distinguishing Feature of How Municipal Bonds Are Taxed?

Municipal bonds are exempt from federal taxes and are often exempt from state taxes. If the bond is acquired from a state other than the purchaser’s home state, the home state may tax the bond’s interest income.

Alternatively, if the bondholder sells the bond and makes a profit, they must pay capital gains tax. Furthermore, if bonds are acquired at a discount on the secondary market, capital gains tax may be levied when the bond is redeemed.

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What Happens to Muni Prices When Taxes Increase?

Because municipal bonds are normally tax-free, they become an appealing investment when taxes rise. As demand for municipal bonds grows, so do their prices.

How Are State Municipal Bonds Taxed?

Municipal bonds issued by the state are exempt from federal taxes and are often exempt from state taxes as well. Munis are often exempt from state taxes if the bond issuer is not located in the purchaser’s home state.

However, interest income is taxable for citizens in states such as Oklahoma, Illinois, Iowa, and Wisconsin. In states where there is no income tax, the purchaser may buy munis from any state without incurring any state tax liability.

Do Municipal Bonds Show Up on 1099 Tax Forms?

Municipal bond interest is reported on Form 1099-INT. Despite being recorded, federal taxes are not owed.

Are Municipal Bonds ETFs Tax-Exempt?

Municipal bonds ETFs are normally tax-free if they solely invest in tax-exempt bonds. However, if the municipal bond ETF contains both tax-free and taxable interest, federal and state taxes may be owed.

How Do I Buy Tax-Free Municipal Bonds?

Municipal bonds may be acquired via a municipal securities broker-dealer or bank, from an investment adviser, through a self-managed account, or in a muni mutual fund or exchange-traded fund (ETF).

The Bottom Line

While standard and zero-coupon municipal bonds are appealing investments for many because of the tax benefits, you should be aware of the possible tax responsibilities before making a purchase. You may be startled by an unexpected tax charge if you do not do sufficient due diligence.

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