Bonds used to fund local and state government projects like buildings and highways are afforded tax-exempt status at the federal level. Plus, people who purchase bonds issued by their states or localities may not be required to pay state or local taxes on the interest. That means some municipal issues have triple tax-free status. 4
Full Answer
What is the return on investment of a city bond?
A term bond is usually repaid at a single maturity date or during limited intervals. Although investors can sell municipal bonds before their maturity dates, investors will not receive their full return on investment unless the bonds reach their maturities. The return on investment of a city bond is called its yield.
Do you pay taxes on city bonds?
You'll catch a tax break from federal and some state income taxes if you invest in city bonds, but your investment is not always completely free from other tax liabilities, namely: State taxes. If you invest in a bond that's issued by a state other than where you live, you'll typically pay taxes on your interest income.
What are the tax implications of buying municipal bonds in another state?
If an investor buys the muni bonds of another state, their home state may tax interest income from the bond. It is beneficial to check the tax implications of each specific municipal bond before adding one to your portfolio, as you might be unpleasantly surprised by unexpected tax bills on any capital gains.
Can the issuer buy back its own bonds?
Some bond issues will expressly prohibit the issuer from buying back any of its bonds, although this would be unusual. If there is an express prohibition look carefully at its scope as there may be ways to structure round the prohibition.
What happens when a city sells bonds?
By purchasing municipal bonds, you are in effect lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or “principal.” A municipal bond's maturity date (the date when the issuer of the bond repays the principal) may be ...
Are city bonds taxable?
Income from bonds issued by state, city, and local governments (municipal bonds, or munis) is generally free from federal taxes. * You will, however, have to report this income when filing your taxes. Municipal bond income is also usually free from state tax in the state where the bond was issued.
What is the tax treatment of municipal bond interest?
Income from investing in municipal bonds is generally exempt from Federal and state taxes for residents of the issuing state. While the interest income is tax-exempt, any capital gains distributed are taxable to the investor.
How can cities pay back general obligation bonds?
A general obligation (GO) bond is secured by an issuing government's pledge to use all available resources — even tax revenues — to repay holders of the bond. At the local government level, pledges may include a pledge to levy property taxes to meet the local government's obligation on the bondholders.
How do you know if a municipal bond is taxable?
Although municipal bonds generally aren't subject to federal taxes, the IRS does include income from such bonds in your modified adjusted gross income (MAGI) when determining how much of your Social Security benefit is taxable.
Which municipal bonds are tax-exempt?
Municipal bonds (also known as "munis") are fixed-income investments that can provide higher after-tax returns than similar taxable corporate or government issues. In general, the interest paid on municipal issues is exempt from federal taxes and sometimes state and local taxes as well.
Is municipal bond interest taxable IRS?
Interest on any state or local bond is not included in gross income, except as provided under IRC § 103(b): Nonqualified private activity bonds. A private activity bond must be qualified to be tax-exempt.
Which of the following is true regarding the tax treatment of municipal bonds?
Which of the following is TRUE regarding the tax treatment of municipal bonds? AInterest and capital gains are taxable.
Are general obligation bonds tax exempt?
The City's general obligation bonds may also be sold as exempt from both state and federal taxes. Good credit ratings and tax exemption means investors are willing to receive the lowest possible interest rates when purchasing general obligation bonds.
What is a general obligation refunding bond?
Refunding bonds are bonds that are issued to replace and refinance outstanding general obligation or revenue bonds (chapter 39.53 RCW). The use of a refunding mechanism is often driven by the desire to lower interest rates and reduce payment amounts on older, more expensive debt.
Why do municipalities issue bonds?
Municipal securities, or "munis," are bonds issued by states, cities, counties and other governmental entities to raise money to build roads, schools and a host of other projects for the public good.
What is the tax rule for muni bonds?
This nugget of tax law states that if you purchase a bond at a discount and the discount is equal to or greater than a quarter-point per year until maturity, then the gain you realize at the redemption of the bond (par value minus purchase price) will be taxed as ordinary income, not as capital gains. This could mean the difference between paying 15% and 37% on the gain 2 for those in the top tax bracket.
Why are municipal bonds important?
Municipal bonds are debt securities issued by state, city, and county governments to help cover spending needs. From an investor's perspective, munis are interesting because they are not taxable on the federal level and often not taxable at the state level. Munis are often favored by investors in high-income tax brackets because ...
What happens if you sell a zero coupon bond?
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.
What is a muni bond?
A bond is a debt security issued by a company or government to raise money and cover spending needs. A municipal bond, also known as a muni, is debt security used to fund capital expenditures for a county, municipality, or state. Municipal bonds are commonly tax-free at the federal level ...
Is a muni bond federally taxed?
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.
Is a muni bond tax exempt?
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.
Do municipal bonds have federal or state taxes?
Municipal bonds are free from federal taxes and are often free from state taxes. If the bond purchased is from a state other than the purchaser's state of residence, the home state may levy a tax on the bond's interest income.
Why do investors like municipal bonds?
Investors favor municipal bonds for a variety of reasons. The most appealing features of bonds issued by states and municipalities are their federal tax-exempt status and their positioning toward the lower end of the risk spectrum. 1 While stable, income-producing, debt issues seem to warrant a position in anyone’s portfolio, ...
What is the yield of a 20 year municipal bond?
A 20-year municipal bond that yields 2.5% to an investor in a 25% tax bracket, or a 3.3% tax-equivalent yield, would offer attractive real returns in some years and barely keep pace with inflation in other years. 4 . One of the main objectives for investors is that they do not outlive their nest egg.
What is a tey bond?
Tax-equivalent yield (TEY) is the yield that a taxable bond must hold to equal or exceed the tax-adjusted yield of a municipal bond. Tax Equivalent Yield = Tax-Free Yield/ (1 – Tax Rate). Therefore, higher-income investors (with theoretically higher tax bills) are likely to benefit more from municipal bond yields than individuals in lower tax ...
Is municipal bond investment tax exempt?
Debt securities used to fund local and state government projects, such as buildings and highways, have long been afforded tax-exempt status at the federal level. Furthermore, residents who purchase bonds issued by their states or localities may not be required to pay the corresponding state or local taxes levied against nonresidents. Thus, certain municipal issues receive triple tax-free status. 2
Is it safe to invest in municipal bonds?
Investing solely in low-yielding municipal bonds, while a safe approach, forsakes growth alternatives that exceed average rates of inflation and do not erode purchasing power. An equitable balance between municipal bonds and (relatively riskier) equities may help offset the risks of eroding purchasing power.
Is municipal bond interest rate stable?
Interest Rate Risk. With respect to principal, investment-grade municipal bonds tend to be stable. Since most issuers of tax-free debt have taxing authority, the risk of default among governmental entities is low. However, the principal of muni bonds is inversely proportionate to interest-rate movements, as with any other bond.
What is the return on investment of a city bond?
The return on investment of a city bond is called its yield . The current yield represents the interest payments you receive, expressed as a ratio of the dollar amount of interest paid in a year to its purchase price, converted to a percentage. The yield-to-maturity represents the total amount of money you’ll make in principal and interest over the life of the bond if you hold it to its maturity. Yield-to-call represents the return on your investment if the city “calls,” or pays your bond in full before its maturity date.
How do investors earn money on city bonds?
Investors earn money on city bonds when the city pays interest on the investment at certain intervals, which are defined in the bond parameters. Bond investors are essentially lending money to a city in return for the interest income they make on the city bonds. And on the maturity date of the bond, the city returns an investor’s initial investment.
Why are city bonds attractive?
City bonds are attractive to many investors because of their tax-exempt benefits. Typically, the interest income you make from your investment in a city bond is not only exempt from federal income tax, but it’s often exempt from state and local taxes as long as you live in the state where a bond is issued. The SEC recommends talking to a tax professional if you're considering investing in a municipal bond to find out if the bond is eligible for tax-exempt benefits.
Why do we have municipal bonds?
You may be familiar with municipal bonds because of their appearance on your local tax ballot through a process called a bond referendum. Because bonds can raise taxes, which allows the city to pay the investors (or bondholders), some cities let their voters decide the fate of some bond issues. For example, if the city is considering a new school, it may let its voters decide whether to approve a bond that would fund the school. In other cities, the city government doesn’t have a choice about allowing voters to decide the fate of certain bond issues if the city’s constitution or local ordinances mandate that the taxpayers must cast the deciding vote. Bonds can also raise money to build city airports or repair infrastructures such as roads and bridges.
How often do city bonds pay interest?
City bond investors typically receive interest payments on a semi-annual basis – every six months.
What is bond interest rate?
Bond interest rates are also called coupon rates, and they are typically fixed rates; they do not fluctuate or adjust over the life of the bond. Interest rates follow market trends and can vary widely, depending on which bonds you choose as investments.
What is serial bond?
Serial bonds are groups of bonds that mature at different intervals during the series. The series may span 20 years with different maturity dates at each year during the series. Term bonds typically have longer maturity dates; for example, 20 to 30 years.
Publication 550 - Investment Income and Expenses
This publication provides information on the tax treatment of investment income and expenses. It explains what investment income is taxable and what investment expenses are deductible. It explains when and how to show these items on your tax return.
Publication 915 - Social Security and Equivalent Railroad Retirement Benefits
This publication explains the federal income tax rules for social security benefits and equivalent tier 1 railroad retirement benefits. Receipt of interest on tax exempt bonds may impact the taxability of social security benefits, as described in this publication.
Publication 1212, Guide to Original Issue Discount (OID) Instruments
This publication helps brokers and other middlemen identify publicly offered original issue discount (OID) debt instruments they may hold as nominees for the true owners, so they can file Forms 1099-OID or Forms 1099-INT as required.
Tax Topic 403 - Interest Received
Most interest that you either receive or is credited to an account that you can withdraw without penalty is taxable income in the year it becomes available to you. However, some interest you receive may be tax-exempt.
How does secondary market premium municipal bond amortization work?
Secondary market premium municipal bonds must be amortized on a straight line basis over the life of the bond. Each year, the amortization amount reduces non-taxable interest income received; and reduces the bond's cost basis.
Is 5% coupon taxed?
While the 5% coupon is not taxed, the 1% annual gain is taxed as interest income received. For someone in the 30% tax bracket, .3% of the 1% annual gain goes to tax, and .7% of the return is kept after tax. Thus, the after tax return is about 5.7%. This is a very difficult question.
Is municipal premium deductible?
The premium on municipal premium bonds must be amortized over the bond's life, but is not deductible for tax purposes . The yield on this bond consists of 2 components: the annual 6.50% coupon rate and the annual 1% loss of the premium (20 point premium amortized over 20 years = 1 point loss per year).
Can municipal bonds be amortized?
Municipal bonds purchased in the secondary market at a premium may be amortized at the option of the bondholder. Municipal bonds purchased in the primary market at a premium must be amortized. Municipal bonds purchased in the secondary market at a premium must be amortized.
Is there tax on OID bonds?
no tax on the discount of the OID bond; while the discount will be taxed as interest income on the market discount bond. If a municipal bond is issued at a discount, this occurred only because the bond offered a rate of interest that was lower than the market.
Is municipal interest income taxable?
Municipal interest income is not taxable by the Federal government. All expenses associated with keeping municipal bonds are not tax deductible. Because municipal interest income is not taxable by the Federal government , all expenses associated with keeping municipal bonds are not tax deductible.
Is municipal bond capital gains taxable?
Only the interest income from municipal securities is exempt from Federal income tax; it is still subject to State and Local tax unless the bond is purchased by a resident of that State.
What Are The Taxation Rules For Bond Investors?
Government Bonds
- The interest from Treasury bills, notes and bonds is taxable at the federal level, but not the state and local level.1 Certain U.S.government agency securities are also taxable at the federal level, but exempt from state and local taxes. This includes bonds from the Federal Home Loan Bank, Financing Corporation, and Tennessee Valley Authority, among others.2
Municipal Bonds
- Municipal bonds are often favored by high-income investors looking to reduce their taxable investment income. The interest from these bonds is tax free at the federal, state and local levels, as long as investors reside in the same state or municipality as the issuers. However, those who buy municipal bonds in the secondary market, then later sell ...
Corporate Bonds
- Deemed the simplest type of bond, from a tax perspective, corporate bonds are fully taxable at all levels. Because these bonds typically contain the highest level of default risk, they also pay the highest interest rates of any major category of bond. Therefore, investors who own 100 corporate bonds at $1,000 par value, with each paying 7% annually, can expect to receive $7,000 of taxabl…
Capital Gains
- Regardless of the type of bonds sold, any debt issue traded in the secondary market will post either a capital gain or loss, depending on the price at which the bonds were bought and sold. This includes government and municipal issues, as well as corporate debt. Gains and losses on bond transactions are reported the same way as other securities, such as stocks or mutual funds, for …
Amortization of Bond Premium
- As discussed, when a bond is issued at a discount, a pro-rated portion of the discount is reported as income by the taxpayer, every year until maturity.1When bonds are purchased at a premium(greater than $1,000 per bond), a pro-rated portion of the amount over par can be deducted annually, on the purchaser's tax return. For example, if an investor buys 100 bonds for …
The Bottom Line
- If taxable bond income is a major component of your annual taxes, consider hiring a certified public accountant to assist you in annual tax planningstrategies.
Overview of Municipal Bonds
Municipal Bonds and Capital Gains
Municipal Bonds and "De Minimis"
Municipal Bonds and Federal Taxes
The Alternative Minimum Tax
Zero-Coupon Municipal Bonds
Muni Bond Taxes FAQs
- What Is the Distinguishing Feature of How Municipal Bonds Are Taxed?
Municipal bonds are free from federal taxes and are often free from state taxes. If the bond purchased is from a state other than the purchaser's state of residence, the home state may levy a tax on the bond's interest income. Alternatively, if the bondholder sells the bond and there is a g… - What Happens to Muni Prices When Taxes Increase?
Because municipal bonds are generally free from taxes, they become an attractive investment when taxes increase.6 Demand for munis increases, and, as a result, so do their prices.
The Bottom Line