How Are Municipal Bonds Taxed?

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Municipal bonds appeal to investors because their interest payments are exempt from federal income taxes and, in many cases, state taxes as well. But there are instances where taxes come into play for municipal bond investors and figuring it out can sometimes get complicated.

Here’s what investors should know about how municipal bonds are taxed.

What are municipal bonds?

Municipal bonds are bonds sold by state and local governments to fund various projects such as schools, road construction or just to fund daily operations. One of the major features of most municipal bonds is that the interest payments are not subject to federal income tax and are often exempt from state taxes as well. Municipal bonds are also known generally for having very low credit risk.

When you’re comparing the yield on a municipal bond with that of a taxable bond, you’ll want to calculate the tax-equivalent yield, so you can account for the tax savings that come with the municipal bond.

Tax-equivalent yield = Municipal bond yield / (1 – your total tax rate)

How municipal bonds are taxed: What investors should know

Taxes are a key part of why investors are interested in municipal bonds. Here’s a breakdown of taxes on municipal bonds:

• Federal income taxes: The interest income on municipal bonds is typically exempt from federal income taxes.
• State taxes: Income from municipal bonds issued in the state where the investor resides is usually exempt from state income tax, though there are exceptions. You’ll typically have to pay state taxes on municipal bonds from outside your home state.
• Capital gains: If you realize a capital gain on a municipal bond, your gain will be subject to the capital gains tax.

The details around these municipal bond issues can occasionally get complicated. Your broker may be able to help with certain reporting details, but you also may benefit from consulting with a financial advisor. Bankrate’s financial advisor matching tool can help you find an advisor in your area.

Below are two more tax issues you may encounter with municipal bonds.

Municipal bonds and the de minimis tax

For municipal bonds purchased at a discount, the de minimis tax rule determines whether the bond’s appreciation at maturity will be taxed at ordinary income or capital gains rates. The de minimis rule says that if the discount is less than 0.25% of the face value for each year from the date of purchase to maturity, then it is treated as a capital gain.

Bonds purchased for less than the de minimis threshold will have their discount accretion taxed at ordinary income rates.

De minimis threshold = lower of par or original issue discount (OID) – (0.25% x years to maturity)

De minimis thresholds for a $10,000 face value municipal bond:

Source: Schwab Center for Financial Research

Municipal bonds and the alternative minimum tax

If you are subject to the alternative minimum tax (AMT), you may have to pay taxes on the interest from certain municipal bonds at the AMT rate. Municipal bonds used to fund projects such as airports, stadiums or other private projects may be subject to the AMT.

You should be able to determine if a bond is subject to the AMT through the bond’s prospectus or your broker.