Most people are unsure whether the interest earned on municipal bonds is taxable or not. There are many rules and regulations surrounding municipal bond interest, and it is not always clear if the income is taxable. But don’t worry, we’re here to help.
Whether you have questions about municipal bond taxes or interest, we have got you covered. In this post, we’ll answer your questions about municipal bond interest such as what is municipal bond interest and how to calculate municipal bond yields?
Is Municipal Bond Interest Taxable? Municipal bond interest is not taxable at the federal level. The interest you receive from a municipal bond is exempt from federal income tax, and in some cases state and local income taxes as well.
Is Municipal Bond Interest Taxable
Municipal bonds are a type of debt security issued by a state, municipality, or other governmental units in the United States. These bonds are also known as “muni bonds” or “muni.” The issuer borrows money from investors by issuing bonds and uses the proceeds to finance public projects such as roads, schools, and hospitals or to refinance existing debt.
Municipal bond interests are exempt from federal taxes and often state and local taxes as well, making them popular with individual investors. The interest paid on municipal bonds is also often exempt from federal taxes. This tax exemption makes them relatively low-risk investments since it’s less likely that the municipality will default on its debt payments.
The taxability of municipal bonds depends on whether the interest earned on them is taxable. Generally speaking, if you live in a state where you pay state income tax, then the interest earned from municipal bonds issued in your state is also subject to state income tax. However, if you live in a state where there is no state income tax (e.g., Texas), then the interest from municipal bonds issued in that state will not be subject to any federal or state income tax.
Let’s look at the two most common types of municipal bonds:
General Obligation Bonds: General obligation bonds are municipal bonds that are backed by the full faith and credit of the issuing municipality which means they are not backed by any specific asset the bondholder can take back. This makes general obligation bonds one of the safest types of bonds to purchase. General obligation bonds are always exempt from federal income tax.
Revenue Bonds: Revenue bonds are issued by municipalities to finance revenue-generating projects like toll roads and concert halls. Revenue bonds are backed by the revenue generated by a specific project, such as a toll bridge or a water treatment plant. The revenue generated by the project itself is used to reimburse the bondholders.
As revenue bonds provide funds for a specific project, which may or may not be completed within budget or on time, they have higher default rates than general obligation bonds. Therefore, it’s crucial to research the issuer’s credit rating before taking any risks with your capital. Interest on revenue bonds may or may not be exempt from federal income tax, depending on the purpose of the bond.
Risk Of Municipal Bonds
Municipal bonds are typically considered a very low-risk investment, as the municipality that issues the bond is unlikely to go bankrupt. But there are a few risks associated with municipal bonds:
Call Risk: Call risk is the risk that a bond issuer may call (or redeem) a bond before it matures, which means the investor would have to reinvest the money at a lower interest rate.
Credit Risk: Credit risk is the risk that the issuer of the bond will not be able to make timely payments of principal and interest.
Interest Rate Risk: Interest rate risk is the risk that the market value of the bond will decrease because of a change in interest rates.
Liquidity Risk: Liquidity risk is the risk that there may not be a buyer for the bond when the holder wishes to sell it.
Inflation Risk: Inflation is a general trend of rising prices. For investors who receive a fixed rate of interest, inflation reduces purchasing power. In addition, it can increase interest rates, which, in turn, reduces bond values.
Calculating Municipal Bond Yields
Tax-equivalent yield is a calculation that takes into account the tax-free nature of municipal bonds. It is used to compare the yield on a muni bond with the yield on a taxable bond of equal maturity.
Tax Equivalent Yield
Calculating the TEY is the first step to comparing munis and determining if they meet your needs.
Tax-equivalent yield = Tax-Free Muni Bond Yield ÷ (1 – your tax rate)
Here’s how you calculate TEY (Tax Equivalent Yield):
- Determine the reciprocal of your tax rate (1 – your tax rate). For example, if you pay 25% tax, the reciprocal would be (1 – .25) = .75, or 75%.
- To find out the TEY, divide this amount into the yield on the tax-free bond. Consider this example: if the bond yields 3%, use (3.0 / .75) = 4%.
By plugging various tax rates into the above equation, you’ll see that tax-free bonds are most suitable to investors in the higher tax brackets because their TEYs are higher.
Municipal bonds issued in your state of residence may be tax-free at the federal as well as state levels. This is referred to as “double tax-free” if you live in a state where municipal bonds are tax-free on the federal and state levels.
Make sure to include the income tax rate of your state in Step 1 when you calculate your reciprocal.
For example, let’s say your federal Tax Rate is 25% and your State Tax Rate is 3%. In Step 1, the appropriate math would be (1 +.28) = 0.72.
How To File Municipal Bond Interest On Federal Taxes
The way that you file municipal bond interest on your federal taxes depends on the type of bond that you own. If you hold a municipal bond that is exempt from federal taxes, then you do not need to file the interest on your federal tax return. However, if you hold a municipal bond that is subject to federal taxes, then you need to file the interest as taxable income.
The bank or other financial institutions will report your interest income on Form 1099-INT. A copy of this form is sent to you and the IRS. This form will tell you how much interest income the institution paid you during the year.
If you receive $10 or more in interest income from a bank or other financial institution, you will get a Form 1099-INT. You will report this income in different places on your tax return, depending on what type of interest you earned.
- Schedule B of Form 1040 contains taxable interest. The total amount from Schedule B would be entered on line 2b in your Form 1040.
- The tax-exempt interest on municipal bonds goes on Line 2a of Form 1040.
- As an adjustment to calculate the alternative minimum, you should report private activity bond interest on Line 2g in Form 6251.
State Taxes On Municipal Bond
Federal taxes on municipal bonds issued by the state are not applicable, and the state that issued the bond is typically exempt from state taxes as well. Municipal bonds are often exempt from state taxes if the issuer is not in the purchaser’s state.
List of States That Tax Municipal Bond Interest
- Oklahoma
- Utah
- Iowa
- Wisconsin
- Illinois
List of States with No Income Taxes
- Washington
- Texas
- Florida
- Alaska
- South Dakota
- Wyoming
- Nevada
In states without income taxes, the purchaser can acquire munis from any state without being liable for state taxes.
Conclusion
Municipal bond interest is generally not taxable at the federal level, but it may be taxable at the state and local levels. So, it is important to consult with a tax professional to determine if municipal bond interest is taxable in your state.
Before investing in municipal bonds, it is important to do thorough research on the asset class as a whole. This includes making comparisons between taxable bonds and municipal bonds on both a qualitative and quantitative basis, as well as calculating the taxable-equivalent yield.
