Municipal Bonds & Taxes

The old adage is there are two things certain in life: death and taxes. While this is certainly true, there are ways to invest without increasing your tax burden. Municipal bonds offer the opportunity to generate income in your account free from federal and, in some cases, state and local taxes.

For many investors, the primary attraction of investing in municipal bonds is their tax advantage. That is why they may be especially attractive to high net worth or retired investors. In today's climate, municipal bonds can be a part of any diversified portfolio.

Tax Exemptions

In general, the municipal body issuing the bond - whether it's your state, a local municipality or the federal government - will not tax individuals on the interest income arising from the purchase of the bond. That means, for example, that a bond issued by an agency of the state in which you live will rarely be subject to state income taxes. However, if you purchase a municipal bond from another state, your state will likely tax your interest income. This acts as a subtle incentive for investors to put their money into their own state and local bonds to invest in their local community.

The federal government also will not tax interest income from state bonds, but states may tax income from federal bonds.

Capital Gains & Losses

While the interest income from municipal bonds may be exempt from certain taxes, the capital gains or losses from the sale of such a bond are subject to federal income taxes. Your capital gain or loss is the difference between the sale price of the bond and your cost basis, or the amount of money you originally paid for the bond. Capital gains are taxed as either long-term (held for more than 12 months) or short-term (12 months or less). Consult your tax professional for more information about calculating capital gains and losses.

Discounts

Municipal bonds are sometimes purchased for less than their value, known as par, and different types of discounts are taxed differently. An original issue discount (OID) occurs when a bond is issued at a price below its redemption value, and the amount of the discount is subject to the same exemptions as interest income for that bond. For example, if a $5,000 bond is issued for $4,900, the $100 OID is treated as additional interest earned and is tax-exempt.

If the bond is purchased at a market discount, on the other hand, the difference between the purchase value and redemption value of the bond is taxable because it arises out of market forces and is not the result of action by the issuer. An example of a market discount would be if the bond is issued at par or at a premium to par and is later purchased on the secondary market at a price less than par.

Advantages & Disadvantages

Like any investment, municipal bonds have several potential advantages and disadvantages for investors.

Advantages of investing in municipal bonds:

  • Income free from federal, and, in some cases, state and local taxes
  • Relative safety in regards to payment of interest and repayment of principal
  • Dependable income
  • Wide range of choices across investment quality, maturity, and geographical location

Disadvantages of investing in municipal bonds:

  • Lower yield and income than other asset classes
  • Risk of underlying issuer
  • Risk of guaranty corporation providing bond insurance
  • Liquidity risk

Scottrade has an advanced Municipal Bond Search that can assist in locating a bond that meets your criteria. You can also use the Tax Free vs. Taxable Yield Comparison Calculator to determine the significance of the tax advantage. This and other helpful tools and information are available on the CDs & Bonds page under the Quotes & Research tab inside your Scottrade account.

Bonds are subject to a variety of risks and loss of principal invested. New issue offerings are sold by prospectus or offering circular available at www.scottrade.com. Investors should read these carefully.