Tax Pros and Cons of Municipal Bonds

Balanced view of investment tax aspects

Municipal bonds (often called “munis” for short) may be attractive to high-income taxpayers, but there are a number of potential tax drawbacks as well. Here is a brief look from both sides of the fence.

Tax Pros of Munis

First, and most important, the interest income is exempt from federal income tax. For example, if you earn a 4% return on a taxable investment and you are normally in the 25% bracket, your after-tax return is only 3%. Even worse, it declines to 2.42% for someone in the current top 39.6% bracket. Conversely, a tax-free muni yielding 4% is the equivalent of a taxable bond yielding (not counting other investment characteristics) 6.62% for a top-bracket taxpayer.

Second, for munis issued within your own state, the interest income is generally exempt from state income tax. This extra tax break effectively increases the after-tax return for certain taxpayers.

Third, the interest income does not count toward the calculation of your adjusted gross income (AGI). Therefore, investing in munis can provide other tax savings on your federal return.

Fourth, the interest income does not count in the calculation of the current 3.8% surtax on net investment income (NII). Thus, unlike most income items, it cannot increase or trigger the NII tax.

Tax Cons of Munis

  • The interest income received from munis issued by an entity in another state may be subject to state income tax. The state tax exemption, when available, applies only to munis issued in your home state.
  • There is no tax benefit if you sell a muni purchased at a premium. For instance, if you buy a muni for $10,500 that will be worth $10,000 if you hold it until maturity, you can’t subsequently claim a $500 loss on your tax return. The premium must be amortized over time.
  • The income from “private activity” bonds is an adjustment item for the alternative minimum tax (AMT). This could force you to pay the AMT instead of regular income tax or increase existing AMT liability.
  • If you sell a muni at a profit, you pay a capital gains tax on the sale. Say you acquire a muni with a face value of $10,000 and sell it for $11,000. The $1,000 gain is taxable as a capital gain.
  • The calculation of the tax on Social Security benefits includes tax-free municipal bond income. Depending on your situation, up to 85% of the benefits received may be subject to tax.
  • If you sell a discounted muni, your profit is taxed as ordinary income to the extent of the accrued discount. The particulars are complicated, so contact your tax adviser.

Although munis can be a good deal for investors, proceed with caution. Weigh all the pros and cons before you invest.

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