Tax Pros And Cons Of Municipal Bonds

Published Wednesday, October 29, 2008 at: 7:00 AM EDT

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For many investors, an investment in municipal bonds can be a sweet deal. Like other bonds, munis provide regular interest payments. But whereas interest on Treasury and corporate bonds is taxed as regular income, at a rate as high as 39.6% plus the applicable state income tax rate, the income from munis is exempt from federal tax and may also avoid state taxes. The same is true of distributions from a qualified municipal bond fund. And while munis typically offer lower yields than taxable bonds, municipal bonds and bond funds may provide higher after-tax returns to investors in high tax brackets. But munis also come with several drawbacks, and if you’re not careful, your investment in municipal bonds or bond funds could trigger unexpected tax liability.

On the plus side, there are at least four significant tax advantages to investing in munis.

1. First, of course, is that exemption from federal income tax. Suppose you own a $10,000 corporate bond that pays 6% interest, and you’re in the 25% federal income tax bracket. Though you’ll receive $600 in annual income, you’ll lose $150 to the IRS, leaving you with only a 4.5% after-tax return. But with a muni, federal tax isn’t an issue.

2. The interest income from munis is also exempt from state tax as long as the bonds are issued within your state. That state tax break effectively increases the after-tax return on your investment.

3. Interest payments from munis don’t increase your adjusted gross income (AGI). That’s beneficial because many tax breaks are phased out when AGI exceeds specified levels.

4. The higher your income, the more likely you are to gain from an investment in munis. That’s because the value of tax-exempt income rises as you move into higher tax brackets. For example, if you’re in the 25% bracket, a municipal bond paying 4% will give you as much after-tax income as a taxable bond with a 5.33% yield. But if you’re in the 39.6% bracket, it will take a yield of 6.62% to match the muni’s 4%. The accompanying chart—“What’s A Muni Worth To You?”—illustrates this notion of “taxable-equivalent yield.”

Yet as helpful as muni investments may be to many investors, they also bring potential tax traps. Consider these six:

1. If your municipal bonds are issued by an entity in another state, you’ll owe state income tax on the interest you receive.

2. If you sell a municipal bond for more than its face value, you may owe federal capital gains tax. The prices of munis, like those of other bonds, fluctuate with changes in interest rates, and if rates dip below the coupon rate on a bond you own, another investor may be willing to pay a higher price for it. But if you bought a $10,000 bond at its face value and sell it for $10,500, you’ll pay capital gains tax on your $500 profit. (The capital gains rate for most taxpayers is 15% on investments held for more than a year; short-term gains are taxed as ordinary income.)

3. The sale of a municipal bond can also result in ordinary income tax. Suppose you acquire a discounted muni in the secondary market and then sell it. Your profit will be taxed as ordinary income to the extent of the accrued discount. For example, if you pay $9,500 for a muni with a face value of $10,000 and a maturity of 10 years and then sell it for $9,800 after five years—at a $300 gain—$250 of your profit will be taxed as ordinary income and $50 taxed as a capital gain.

4. Selling a muni bought at a premium, however, won’t produce any tax benefit. For example, if you buy a bond for $10,500 that will mature at $10,000 and you hold it until maturity, you can’t claim a capital loss or any other deduction on your tax return. Tax rules require you to amortize the premium over the life of the bond.

5. Interest payments from “private activity” municipal bonds, used to finance airport construction or other nongovernmental projects, aren’t exempt from federal tax for taxpayers who owe the alternative minimum tax (AMT).

6. Owning munis could result in tax on Social Security retirement benefits. Normally, Social Security benefits are exempt from increased tax. However, if your “provisional income” exceeds specified levels, you’ll be taxed on up to 85% of your benefits. Provisional income is equal to the sum of your AGI plus any tax-exempt interest—such as income from munis and municipal bond funds—and 50% of your Social Security benefits.

Weighing munis’ potential benefits and drawbacks involves complex calculations and depends on each investor’s needs and circumstances. If you’d like to discuss the possible role of municipal bonds or bond funds in your portfolio, please give us a call.

This article was written by a professional financial journalist for Advisor Products and is not intended as legal or investment advice.

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