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How are Municipal Bonds Taxed?

November 10, 2022

The tax-exempt status makes these bonds appealing to high-income investors, and their steady, reliable income payments often are attractive to retirees. But there’s a tradeoff. Read on.

In today’s turbulent markets, many investors are looking for safer alternatives. One option to consider is municipal bonds. While they’re often touted as “tax-free,” the truth is a little more complicated. Here’s what you need to know so you don’t end up with an unexpected tax bill.

Muni Bonds 101

State and local governments issue municipal bonds to fund public projects such as schools, sewers, roads and airports. The bond holder receives fixed payments over the bond’s term, usually semiannually, and the principal is returned at the maturity date.

The tax-exempt status makes these bonds appealing to high-income investors, and their steady, reliable income payments often are attractive to retirees. But there’s a tradeoff: These benefits are offset by lower yields than you might earn with other investments.

Tax Issues

Before investing in a municipal bond, you should evaluate the tax implications, including the following:

Income taxes. Municipal bond income generally isn’t subject to federal income taxes. But you may have to pay federal income tax on certain “private-activity” bonds, which are issued for private projects (for example, stadiums), rather than projects that benefit the general public. It’s worth noting that private-activity bonds may not be excluded from alternative minimum tax (AMT).

The income also may be free from state and local taxes, especially if you live in the state where the issuer is located. However, the tax treatment varies by state. Some states tax interest on their bonds, while others don’t tax bond interest from any state. Some states tax interest on out-of-state bonds only. In addition, a state that does tax interest on in-state bonds might exclude specific bonds at the time of issuance. Make sure to review the guidance for each applicable state before investing.

Capital gains tax. Municipal bond holders typically hold these investments until maturity, but sometimes life gets in the way. If you sell before the bonds mature, for a price greater than your cost basis, you’ll need to pay capital gains tax on the gain. You also might incur capital gains tax if you buy municipal bonds on the secondary market at a discount from par (or face) value.

Under the “de minimis” rule, if you buy a tax-exempt municipal bond at a discount of a quarter-point or more per year from purchase to maturity, the gain realized at redemption (par value less purchase price) is taxed at ordinary income rates, not at the more favorable capital gains rate. That could mean a 37% income tax rate versus a 15% capital gains tax rate for bond holders in the highest tax bracket. If you don’t pay attention to the discount amount, your after-tax return could be far lower than expected.

Social Security and Medicare. The IRS includes income from municipal bonds in your modified adjusted gross income (MAGI) for purposes of determining the amount of your Social Security benefits that are taxable. The inclusion can be significant.

For example, up to 50% of Social Security benefits could be taxable for individuals with MAGI between $25,000 and $35,000 (between $32,000 and $44,000 for joint filers). And up to $85% of the benefits could be taxable at MAGI levels above these ranges.

Your MAGI also determines the premiums you pay for Medicare Part B and prescription coverage. Premiums are higher for single filers with MAGI above $91,000 ($182,000 for joint filers).

Check First

Municipal bonds have the potential to be tax-free, but it’s not automatic. Our Private Client Services team can help you conduct the necessary due diligence before you purchase bonds to help you avoid the tax traps.

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