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Tax-Free Income: A Quick Review of Municipal Bonds

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Normally, when income is recognized, whether through wages, dividends, or interest, you will incur income taxes. In other words, if you make money, you owe taxes. Happily, there are exceptions, one of which is municipal bonds. Municipal bonds and municipal bond funds generate federally tax-free income.

 

The tax advantages of municipal bonds:

 

You pay zero federal tax on municipal bond investment income. This makes municipal bonds an attractive option for those sensitive to taxes. What’s more, municipal bond income isn’t counted for net investment income tax purposes (NIIT), which is an additional 3.8% surtax levied on certain investment income sources. Additionally, if the municipal bond you own is issued by an authority within the state where you reside, it is also exempt from state income tax.

While the benefits of municipal bonds may be attractive for many investors, there are additional considerations:

Alternative minimum tax. If you invest in certain private activity bonds — such as some bonds used to finance projects like a stadium — the income may cause alternative minimum tax complications.

Capital gains tax. When you sell a municipal bond at a profit, you owe capital gains tax on the sale. For instance, if you buy a bond for $5,000 and sell it for $6,000, you’re taxed on the $1,000 gain. The interest may be tax-free, but the capital gain is not.

State tax possibility. If you invest in municipal bonds issued by another state, the interest income is taxable by the state where you reside.

Bond risk. Municipal bonds, just like corporate bonds, carry a risk of default.

Taxes on Social Security benefits. The amount of your Social Security benefit that is subject to income tax is based on a calculation that specifically includes tax-free municipal-bond income.

Investing in municipal bonds can provide tax-free income, especially for those in higher income tax brackets. If we can help you understand where municipal bonds fit in a diversified portfolio, please be in touch.

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