While investing in tax-free municipal bonds generally provides tax-free interest, you may still encounter tax consequences. Keep reading to learn more about the potential tax and other financial consequences of investing in tax-free bonds.
Purchasing tax-exempt bonds
There are no immediate tax consequences for purchasing a tax-exempt bond for its face amount, whether on the initial offering or in the market. If you buy a tax-exempt bond between interest payment dates, however, you will owe the seller any accrued interest since the most recent interest payment date.
The amount of interest accrued is then treated as a capital investment and will be deducted as a return of capital from the following interest payment.
Is interest included in income?
Generally speaking, interest received on a tax-free municipal bond will not be included in gross income—but it may be used for alternative minimum tax (AMT) purposes. Tax-free interest may be appealing, but it’s important to note that compared to an otherwise equal taxable investment, a municipal bond may pay a lower interest rate. What really matters is the after-tax yield.
The after-tax yield for a tax-free bond is typically equivalent to the pre-tax yield. Alternatively, the after-tax yield for a taxable bond is determined by your interest amount after accounting for the increase in your tax liability due to annual interest payments—which is based on your effective tax bracket.
Taxpayers in higher brackets tend to be more interested in tax-free bonds, since excluding interest from income offers a greater benefit. Taxpayers in lower brackets, however, may find that the tax benefit from excluding interest from income may not adequately make up for a lower interest rate.
While not taxable, municipal bond interest still shows on a tax return. This is because tax-exempt interest is taken into account when determining the amount of taxable Social Security benefits (and other tax breaks).
Tax-exempt bond interest and the NIIT
Another tax advantage of tax-exempt bond interest is that it is exempt from the 3.8% net investment income tax (NIIT).
This is imposed on the investment incomes of individuals whose adjusted gross income exceeds:
- $250,000 for joint filers
- $125,000 for married filing separate filers
- $200,000 for other taxpayers
What about retirement accounts?
Because the income in your traditional IRA or 401(k) isn’t currently taxed, it generally isn’t logical to hold municipal bonds in those accounts. Once you start taking distributions, however, the entire amount withdrawn may be taxed.
For those who want to invest retirement funds in fixed-income obligations, it’s typically a good idea to invest in higher-yielding taxable securities.
Consult with a tax professional
Before investing in tax-free municipal bonds, it’s important to fully understand the tax implications—and those mentioned above are only some of the tax consequences. If you need assistance understanding and applying tax rules to your situation, contact us to work with a knowledgeable tax advisor.
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