Municipal bonds can be an attractive investment if you’re looking for bonds that generate consistent income with low credit risk. Tax-free municipal bonds may be even better since they’re tax-exempt in nature. But there’s one thing to know about investing in muni bonds: tax-exempt status is not always guaranteed. There are certain scenarios in which you may still have to pay taxes on income from municipal bonds. If you hold these bonds in your portfolio or are thinking of investing in them, it’s important to understand what that could mean from a tax perspective.
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What Are Tax-Free Municipal Bonds?
A bond is a debt instrument. When a bond is issued, investors can buy that bond, allowing the issuer to raise money. That money is then paid back to investors with interest. Once the bond reaches its maturity date, the principal or initial investment is returned to investors as well.
Municipal bonds are bonds that are issued by government entities, including municipalities, counties or states. These bonds are typically used to fund public works projects, such as road maintenance or the construction of new schools. One thing these bonds have in common is that they generally fall into the tax-free municipal bonds category.
That’s because the federal government usually classifies municipal bonds as tax-exempt. State tax agencies can also classify them as tax-exempt. That means you wouldn’t be subject to tax on the interest payments you receive from one or more muni bonds you hold in your portfolio.
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.
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 need to sell a municipal bond before its maturity date, then you could be subject to capital gains tax if you sell it for more than the initial purchase price you paid.
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’s important because it could mean paying a higher tax rate than the more favorable capital gains tax rate.
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.
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.
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. Social Security may still be decades away for you but 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 interested in tax-exempt munis, the first step is doing a little research. Specifically, you’d want to look at individual municipal bonds to determine if they would, in fact, be tax-free for you with all things considered. And keep in mind also that some municipal bonds are taxable when they’re issued, regardless of your personal financial situation.
Next, you can look at the specifics of individual bonds. That includes checking the credit rating and possible default risk, maturity term and the potential yield you could get from the bond. Generally, municipal bonds have a low default risk since they’re issued by government agencies. But it’s still important to look for bonds that have a strong credit rating. You’d also want to select muni bonds that have a maturity term and yield potential that align with your investment goals.
When you’re ready to buy municipal bonds or bond funds you can do so through an online brokerage account. If you don’t have an online brokerage yet, there are a number of options to choose from. As you shop around for the best brokerage accounts, consider things like trading fees and commissions, investment options and minimum investments. This can help you find a brokerage that’s best suited to your needs.
The Bottom Line
Municipal bonds can offer predictability in the form of regular interest payments. And compared to stocks, they tend to be a much safer investment. Before investing in tax-free municipal bonds, it’s important to do your research in order to uncover any potentially hidden tax consequences.
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 up to three 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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