Are Municipal Bonds Exempt From Federal and State Taxes?

When investors buy municipal bonds they are loaning money to state and local governments that use the money for public works and construction projects to benefit taxpayers in that community. Municipal bonds are favored by investors for their tax-exempt status. The interest that investors receive from municipal bonds is taxed by state and local governments, but not by the federal government.

Definition

State, city and local municipalities issue bonds in order to finance specific projects such as roads, hospitals, civic centers, sewer systems and airports. Municipal bonds are generally considered safer investments than corporate bonds because municipalities are less likely to go broke than corporations that issue bonds.

Important Fact

Investors who buy municipal bonds issued by the state in which they live can often receive interest payments that are exempt from state taxes and federal taxes. For instance, if you live in Pittsburgh and purchase a bond issued by the state of Pennsylvania, the interest is exempt from state and federal tax. But if you live in Cleveland and purchase the Pennsylvanian bond, the interest will be taxed by the state of Ohio, but not the federal government.

Types

There are two types of municipal bonds: general obligation and revenue bonds. General obligation bonds are backed by the full faith and credit of the taxpayers of the municipality that issues the bond. Investors can sue a municipality that defaults on general obligation debt and states are required to bail them out. Revenue bonds are used to fund specific projects, such as toll roads and stadiums, which will create revenue that will be used to pay interest to investors. Those projects can, and sometimes do, default.

Considerations

The interest payments on municipal bonds are exempt from taxation, but capital gains are not. In other words, if a municipal bond investor sells a bond for a higher price than it was originally purchased for, the capital gains must be reported on federal and state income tax returns.

Expert Insight

Tax exempt municipal bonds are more appropriate investments for people in high tax brackets. They are not suitable for people in low tax brackets. Municipal bonds usually pay less interest than corporate bonds, but they have the advantage of the federal and potential state tax exemption. The amount of tax savings is the biggest factor in deciding if a municipal bond is a better investment than a corporate bond.

References

• Public Bonds: Municipal Bond Basics