Municipal bonds are a compelling option for investors seeking consistent income with minimal credit risk. Tax-free municipal bonds, in particular, offer an added advantage due to their tax-exempt status. However, it’s important to note that this tax-exempt status isn’t always guaranteed. There are specific situations where income from municipal bonds may still be subject to taxation. If you currently own municipal bonds or are considering adding them to your portfolio, it’s crucial to understand how these tax implications could affect your overall investment strategy.
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What Are Tax-Free Municipal Bonds?
A bond is a type of debt instrument that allows issuers to raise capital by selling it to investors. In return, the issuer pays investors regular interest payments. Once the bond reaches its maturity date, the principal — the original amount invested — is repaid to the investors.
Municipal bonds, on the other hand, are issued by government entities such as cities, counties or states. These bonds are typically used to finance public infrastructure projects like road repairs or school construction. What sets municipal bonds apart is their tax-exempt status.
In most cases, the federal government classifies municipal bonds as tax-exempt, meaning investors don’t owe federal taxes on the interest earned. Additionally, state tax agencies may also exempt these bonds from state taxes, further enhancing their appeal.
When Are Municipal Bonds Taxable?
While municipal bonds are generally tax-free at the federal and state levels, there are situations in which you may be subject to tax on these investments. If you hold municipal bonds, it’s important to know when tax might apply and what type of tax you may be subject to. Here’s when you may owe taxes on municipal bonds.
1. Capital Gains
Capital gains tax is generally applied when you sell an investment for more than what you paid for it. Whether you pay the short- or long-term capital gains tax rate depends on how long you held the investment before selling. If you sell a municipal bond before its maturity date, you could be subject to capital gains tax if you sell it for more than the initial purchase price you paid.
2. Buying Bonds at a Discount
If you buy municipal bonds at a discount, you may be subject to something called de minimis tax. This tax rule says that if you buy bonds at a discount that’s equivalent to 0.25% or more each year until the bond matures, any gains you realize when you redeem the bond are subject to ordinary income tax. That could mean paying a higher tax rate than the more favorable capital gains tax rate.
3. State Income Tax
Tax-free municipal bonds can become taxable at the state level if you’re buying them from a state other than the one you live in. Any interest that’s paid on bonds from outside your home state may be subject to your state’s income tax guidelines. It’s also possible that you may have to pay state taxes on interest payments from municipal bonds issued in your state, depending on where you live.
4. Alternative Minimum Tax
The alternative minimum tax (AMT) is a secondary tax system that applies to certain high-income taxpayers. Under this system, certain deductions are no longer allowed. Investors who are subject to alternative minimum tax are required to pay it if the amount owed is higher than it would be under the regular income tax system. The AMT rules allow for certain types of muni bond income to be taxed. So if you’re subject to alternative minimum tax, it’s possible that any tax-free municipal bonds you own could end up being taxable.
5. Municipal Bond ETFs
Municipal bond exchange-traded funds (ETFs) allow investors to hold a collection of muni bonds in a single basket. You may consider municipal bond ETFs if you’d like an easy way to diversify. But it’s important to consider which type of bonds are included. If they’re all tax-free municipal bonds, then you shouldn’t have to worry about any tax implications. On the other hand, federal and state taxes may apply if the ETF holds a combination of tax-exempt and taxable bonds.
Other Considerations for Municipal Bonds
Beyond these situations, there are some other things to keep in mind about municipal bond investments and your finances. For example, there may be tax implications to holding muni bonds when it’s time to begin taking Social Security benefits. The IRS can consider bond interest income as part of your modified adjusted gross income to calculate what part of your Social Security benefits are taxable. Even if Social Security is still decades away for you, it’s important to consider how owning municipal bonds could affect your taxes in retirement.
Another consideration centers on what you might pay for Medicare once you retire. Medicare premiums for Part B and prescription drug coverage are determined by your filing status and your income. While your income from municipal bonds may be tax-exempt, it can still be used to determine how much you’ll pay for Medicare. More muni bond income could mean higher premiums for Medicare.
How to Buy Tax-Free Municipal Bonds
If you’re considering tax-exempt municipal bonds, start with some research to ensure they’re the right fit for your financial goals. Specifically, evaluate individual municipal bonds to determine whether the interest earned would truly be tax-free in your situation. Keep in mind that certain municipal bonds are taxable at issuance, regardless of your financial status.
Next, dive into the details of the bonds you’re evaluating. This includes reviewing the credit rating, assessing the risk of default, and analyzing the bond’s maturity term and potential yield. Municipal bonds are generally considered low-risk since they’re issued by government entities, but it’s still crucial to prioritize bonds with strong credit ratings. Additionally, select bonds with maturity terms and yield potentials that align with your broader investment objectives.
When you’re ready to buy municipal bonds — or invest in municipal bond funds — you can do so through an online brokerage account. If you don’t yet have a brokerage account, there are plenty of options available. While comparing accounts, consider factors such as trading fees, commissions, available investment options and minimum investment requirements. Choosing the right brokerage ensures your investment process is seamless and well-suited to your needs.
Bottom Line
Municipal bonds provide a reliable source of income through regular interest payments and are generally considered a safer investment compared to stocks. They are particularly attractive to investors seeking tax-advantaged income, as the interest earned is often exempt from federal and, in some cases, state and local taxes. However, before investing in tax-free municipal bonds, it’s essential to conduct thorough research to identify any potential tax implications, such as the impact on alternative minimum tax liabilities or taxes on capital gains, if the bonds are sold before maturity. Understanding these details can help you make an informed investment decision.
Tips for Investing
- You can talk to a financial advisor about the pros and cons of tax-free municipal bonds and whether they make sense for you. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s free tool matches you with financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor, get started now.
- Saving for retirement is the first step, but you also need to think about how you are investing the money you save. Use SmartAsset’s asset allocation calculator to figure out what your portfolio should look like.
- Municipal bonds are just one type of bond you might consider adding to your portfolio. You may also choose to diversify with corporate bonds, Treasury bonds, foreign bonds, mortgage-backed bonds, high yield bonds or junk bonds. When comparing bond options, be sure to understand the maturity term and potential yield, as well as the credit rating and default risk. And consider how much of your portfolio you want to commit to bonds versus stocks overall to meet your investment goals.
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