How Are Municipal Bonds Taxed?

While an investor might pay $95.62 if only accounting for capital gains tax, the true value is much lower—only $94.73. At the time of purchase, the buyer must recognize whether the bond is subject to de minimis because the after-tax return could be substantially less than expected.

Municipal Bonds and Federal Taxes

The federal government does not tax most activities of states and municipalities, thereby giving most muni bonds tax-exempt status. However, some activities do not fall under this tax exemption. For instance, coupon payments for muni bonds sold to fund those activities are federally taxed, with one common example is a bond issued to fund a state’s pension plan obligation. When this type of bond is for sale, brokers selling the bond should readily know whether it is taxable.

Another more harrowing example of taxable munis are those that are issued as tax-free, then later become taxable if and when the IRS determines the proceeds are being used for purposes that do not fall under tax-exempt status. This is very rare, but when it happens, it leaves a lot of very unhappy investors; their coupon payments are taxed as ordinary income and, if they choose to sell the bond, the price they receive will be reduced because buyers would require a higher yield on a taxable bond.

Generally, taxable munis are still exempt from state and local taxes, so investors in states with high-income taxes may find that they get a better after-tax return than with other fixed-income investments that are fully taxable at all levels, such as corporate bonds or certificates of deposit.

The Alternative Minimum Tax

Although it is relatively uncommon, some muni bonds are federally taxed if the holder is subject to alternative minimum tax (AMT). If you are unsure whether a specific muni is subject to AMT, consult the broker before purchase.

For example, a bond that is used for a particular municipal improvement that is not backed by the credit of a state or municipality, but rather that of a corporation (such as an airline backing an airport improvement bond), would be subject to AMT.

Zero-Coupon Municipal Bonds

Zero-coupon municipal bonds, which are bought at a discount because they do not make any interest or coupon payments, don’t have to be taxed. In fact, most aren’t. As long as you’re investing in a local municipal bond, taxes won’t be a concern. This provides a big advantage over taxable bonds, even with lower interest. To determine whether or not a tax-free bond is a better option than a taxable bond, simply apply the Tax Equivalent Yield (TEY) formula.

Another important note here is that you will likely be subject to a capital gain or loss if you sell the bond before it matures. If you sell higher than the adjusted issue price, then you book a capital gain. If you sell for less than the adjusted issue price, you suffer a capital loss, which can be utilized to reduce your overall tax bill.

The biggest and most obvious benefit of zero-coupon bonds is that you’re buying the bond at a big discount to its face value. This is also known as the original issue discount or OID. For example, you can buy a $1,000 bond for $500. However, most zero-coupon municipal bonds are sold in denominations of $5,000. Either way, you’re buying at a tremendous discount. This, in turn, allows you to buy more bonds if you so desire. The longer the bond has to mature, the bigger the discount you will receive.

Of course, you have to hold up your end of the bargain to see the greatest benefits. And that simply means that you must remain patient until the bond matures. By doing so, you will see a substantial return that’s also tax-free. And if you’re the type of person who does not like guesswork or worrying about economic conditions, it is worth considering a zero-coupon municipal bond because you will receive one payment at maturity, which is based on the principal invested plus the interest earned (compounded semi-annually) at a predetermined yield.

Most zero-coupon municipal bonds mature between eight and 20 years. If you’re a risk-averse investor and you’re looking towards retirement, then it’s highly recommended that you discuss zero-coupon municipal bonds with your financial advisor.

Municipal bonds are one of the safest investments you will find. Indeed, most zero-coupon municipal bonds are rated A or higher by the rating agencies, but it’s still important to check the quality of the issuer. If you’re uncertain or questioning whether or not you made a good decision, you can ease your mind by purchasing insurance for the bond.

The Bottom Line

While traditional and zero-coupon municipal bonds are an attractive investment for many due to the tax savings, you must understand the potential tax liabilities before making a purchase. In the absence of proper due diligence, you may be surprised by an unexpected tax bill.