It’s my annual “Taxes from A to Z” series! Next up:
Chances are, if you have an investment account, you own municipal bonds. More than 60% of municipal bonds are owned by individuals, often through mutual funds.
Municipal bonds are generally private investments in state and local government projects like schools, hospitals, water projects and roads. When a state or local government needs money for for those projects, it can: (1) cut spending; (2) raise taxes; or (3) borrow money. Since the first two options are often impossible or not palatable, borrowing money is generally the most appealing. But even in the pre-“too big to fail” bank era, banks don’t generally hand over giant checks to cities and towns that might already be struggling to pay bills. Instead, the city or town borrows money from the public with the promise to pay the loan back over time with interest. That loan is called a municipal bond.
The primary appeal of municipal bonds (in addition to traditionally lower transaction costs and smaller investment minimums) is the tax piece: when interest is paid from these bonds, that income is typically tax exempt for federal income tax purposes – that particular tax break dates back more than 100 years.
The tax exempt nature of municipal bonds has been codified in the Tax Code at section 103, which states:
Except as provided in subsection (b), gross income does not include interest on any State or local bond.
So, of course, being a good tax scholar, you’re dying to know those exceptions. They include a (1) Private activity bond which is not a qualified bond (generally, those bonds which finance projects that primarily benefit private parties rather than the general public); (2) Arbitrage bond and (3) Bond not in registered form, etc.
That means, then, so long as a municipal bond isn’t excluded under section 103, it’s tax-favored. The exact amount of tax exempt interest will be reported to you (and to IRS) on a 1099-INT at box 8.
Be careful, though. Just because it’s not supposed taxable doesn’t mean it’s not reportable. You’ll report the tax exempt interest on your form 1040 at line 8b.
You don’t get a pass on all federal income tax consequences with a municipal bond: if you’re subject to AMT (alternative minimum tax), some or all of that interest may be taxable.
Additionally, even though the interest may be tax exempt for federal income tax purposes, you can still recognize taxable gain or loss at the sale of the bond – or if you bought the bond for less than face value.
And one more thing (I know, the hits keep coming): When figuring whether your Social Security benefits are taxable, the formula includes your adjusted gross income (AGI) + your tax exempt interest + 1/2 of Social Security benefits. If the total exceeds certain thresholds (currently, $25,000 for an individual taxpayers and $32,000 for married taxapayers filing jointly), a portion of your benefits may be taxable. That doesn’t mean that the interest is taxable (it remains tax-exempt) but it does figure into your total tax bill.
Municipal bonds can be terrific, tax-favored investment vehicles. However, the tax consequences aren’t necessarily easy to understand. If you have any questions about how they should be reported and taxed, consult with your tax and financial advisors.
