How Are Municipal Bonds Taxed?
Investors choose municipal bonds for their income-producing value. Munis, as they are often called, can be a wise choice because many offer substantial tax advantages. However, municipal bonds are taxed in different ways. The purpose and the terms of particular bond issue determine how the income it generates is taxed. Be sure you investigate and understand the tax status of any municipal bond before you invest your money.
Other People Are Reading
-
Identification
-
The term "municipal bond" is used to refer to both local and state debt securities. Most municipal bonds are either general obligation bonds (backed by the credit and revenue of the issuing government) or revenue bonds, which depend on money derived from the project they fund for payment of interest and principal. The interest paid on municipal bonds is usually exempt from state and local income taxes, at least for residents of that state. Income from municipal bonds may be exempt from federal taxes if the purpose of the bond meets certain federal criteria.
Federal Taxes
-
For a municipal bond to qualify federal tax-exempt status, it must be issued for a purpose that provides a significant benefit to the general public. Most general obligation bonds and some revenue bonds qualify. However, bonds issued to pay for projects like sports facilities or public employee pensions do not meet the federal criteria.
-
State and Local
-
As a general rule, municipal bond income is exempt from state income taxes. This is usually the case even if the bonds do not qualify for exemption from federal income tax. However, many states only extend the tax exemption to residents of the state.
Capital Gains
-
Municipal bonds are traded securities. Consequently, their price varies depending on market conditions. Any difference between the amount you invest in a municipal bond and the price you sell it for is a short- or long-term capital gain or loss. Tax exemptions on income received from the bond do not apply. To calculate municipal gain or loss, add any expenses like broker's fees to the purchase price to find your cost basis. Subtract the cost basis from the price you receive when you sold the bond. If the answer is greater than zero, you have a capital gain. Your must report the gain as income when you file your income taxes.
Tax-Equivalent Yield
-
Municipal bonds with tax exemptions usually have lower yields than corporate and other taxable bonds. Tax-equivalent yield expresses how a municipal bond yield compares to taxable bonds. To calculate tax-equivalent yield, add up the marginal (maximum) tax rates for taxes you will not pay on the bond income. Subtract the total marginal rate from 1.0. Divide the result into the bond's yield to find the tax-equivalent yield. If the tax-equivalent yield is higher than the yields of comparable taxable bonds, then the municipal bond will provide a better return on your money.
-
