A municipal bond is essentially an IOU from a local government. You agree to lend that municipality money for a certain period of time, and they agree to pay you back with interest. Like bonds issued by corporations, they’re structured to give investors a fixed amount of interest for a set period of time, and then return the capital (the bond principal) at the end — if all goes as expected.
While there are several differences between corporate and municipal bonds, an important one is that, usually, the federal government does not tax interest income from municipal bonds — and the state you reside in may not tax it either.
Corporate vs. Municipal Bonds
Income from corporate bonds is taxable, although these bonds often pay a bit more than muni bonds. Also, there’s generally an increased risk of default, whereas municipal bonds tend to pose a much lower default risk. According to the bond-rating service Moody’s, the default rate of municipal bonds was about 0.03% per year between 2009 and 2014 while — over the long term — the default rate on corporate bonds is about 2.5% per year.
Municipal bonds come in two main varieties. General obligation bonds are repaid through taxes that the issuing municipality collects. Revenue bonds are typically issued for a specific infrastructure project, such as a toll road or entertainment venue, and use a portion of ticket sales or toll collections to repay it. Because the interest may depend on the success of the project, they're often considered slightly riskier than general obligation bonds.
Tax Free … Mostly
While the income from muni bonds may be tax free, capital gains are taxable on a short- or long-term basis depending on how long the investment is held. It’s also important to note that not all municipal bonds are tax-free, such as bonds that support an underfunded pension — and there may be other tax implications depending on the circumstances around the sale of a bond. Also, if you’re subject to the Alternative Minimum Tax (AMT), that could trigger a tax on certain types of municipal bonds as well. Your investment advisor should tell you if a particular municipal bond is tax-free in your circumstances.
State tax rules around municipal bonds are complicated. If you buy a municipal bond from another state, your home state may tax the interest income. And in some cases, interest income from bonds issued in your own state may still be taxable at the state or local level. Check with your tax advisor about the laws where you live before making any investment decisions.
There’s another tax issue that could affect you after retirement. The interest income from municipal bonds may not be taxed as income, but it is part of your Modified Adjusted Gross Income (MAGI) when determining how much tax you owe on any Social Security benefits you receive. Depending on the amount of other income, it can also increase your Medicare Parts B and D premiums. So, municipal bond interest income can increase your total tax bill indirectly. Complexities like these is why it’s important to ask a qualified tax advisor to clarify the impact in your particular situation.
Sorting Through the Choices
Municipal bonds are available individually or through a bond fund. A municipal bond fund can also offer tax efficiency as well as pay distributions monthly, quarterly, semi-annually or annually. Always consider taxes when evaluating investment returns. And municipal bonds can play an important part of a tax-efficient investment plan. Make an appointment to speak with your financial advisor to explore how municipal bonds could be part of a tax-smart strategy for you.
Sources
https://www.investopedia.com/articles/investing/040115/should-you-consider-muni-bonds.asp
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