Is Interest From Municipal Bonds Taxable?

Municipal bonds, or munis, are sold by local and state governments to fund public projects such as new schools, hospitals, and infrastructure. While munis have preferential tax treatment, they are not always completely tax-free.

Key Takeaways

• State and local governments issue municipal bonds to fund various projects.
• Municipal bonds are typically exempt from federal, state, or local taxes. But, there are exceptions.
• Different types of munis include general obligation bonds, revenue bonds, private-activity bonds, and more.

Overview of Municipal Bonds

Municipal bonds are issued by state and local governments for expenses incurred on public projects, such as building schools, highways, bridges, and other infrastructure developments. Investing in municipal bonds involves purchasing these debt instruments and lending money to the issuer. In return, you receive periodic interest payments, usually semi-annually, throughout the bond’s term. The term can range from a few months to several decades, depending on the specific bond. At the end of the term, you will receive the full principal amount back, marking the bond’s maturity.

What attracts investors to munis is their potential tax advantages. Interest income earned from municipal bonds is typically exempt from federal income tax. Additionally, if you live in the state where the bond was issued, the interest income is often exempt from state and local taxes too. This tax-exempt status makes municipal bonds particularly appealing to high-earning individuals who want to reduce their overall tax liability.

Taxation of Municipal Bonds

Capital Gains Taxes

Generally, capital gains on stocks and other securities are subject to federal income tax. However, for most investors, capital gains on the sale of municipal bonds are exempt from federal income tax. In other words, you don’t have to pay federal capital gains tax on any profit realized from selling municipal bonds.

Furthermore, if you sell municipal bonds issued by your state of residence, the capital gains are typically exempt from state income tax. This exemption is known as a “double tax exemption.”

But, there are exceptions. In certain cases, such as when bonds get sold at a premium or are deemed “private activity bonds,” a portion of the capital gains may be subject to federal income tax. Additionally, if you purchase bonds at a premium and sell them at a loss, they cannot get used to offset capital gains by providing capital losses. The Internal Revenue Service (IRS) treats tax-free instruments differently than most taxable investments.

The “De Minimis” Tax

The de minimis tax rule applies to munis acquired at a market discount. If you purchase bonds at a discount of more than 0.25% for each year from the purchase date to maturity, gains realized at redemption will get taxed as ordinary income instead of capital gains. The ordinary income tax rate is typically higher than the capital gains rate, which could lead to lower returns than expected.

Consider a bond with a face value of $100 that matures in 10 years. The de minimis “breakpoint” for this bond is $97.50 (100 — [0.25 × 10 years]). If you purchased this bond at a price lower than $97.50, you have to pay ordinary income tax on the discount.

Federal Taxes

While most activities of states and municipalities are tax-exempt at the federal level, including municipal bonds, certain activities, like bond payments for funding state pension plans, are subject to federal taxes. Additionally, municipal bond income is considered when calculating taxable Social Security benefits. In rare cases, tax-free munis may become taxable if the IRS determines that they have been used for non-exempt purposes.

Alternative Minimum Tax

In the U.S., there are 2 income tax systems: ordinary income tax and alternative minimum tax (AMT). The AMT disallows certain deductions allowed in the ordinary income tax code. Taxpayers must calculate their tax liability under both systems and pay the higher amount.

Certain municipal bonds, such as those financing stadiums, airports, or business-like enterprises, may be subject to the AMT. If you are liable for AMT and hold such bonds, your interest income would generally get taxed at the applicable AMT rate, which can be 26%+, especially if you fall within the AMT exemption phase-out range. That means the yield on a municipal bond paying 3.50% would effectively decrease to around 2.6%.

Under the 2017 tax law, the phase-out thresholds for AMT was raised, resulting in fewer taxpayers being subject to the AMT under the new tax laws. The phase-out threshold for married couples filing jointly was $1,079,800 for 2022.

Common Types of Municipal Bonds

General Obligation

General obligation (GO) bonds are backed by the full faith and credit of the issuing government entity, typically state and local governments. The primary source of repayment is the government’s ability to levy taxes to raise revenue. Because, GO bonds are considered relatively low-risk investments, they are typically associated with lower interest rates compared to other types of municipal bonds.

Revenue Bonds

Revenue bonds, or revenue-backed bonds, are not supported by the government’s full faith and credit or taxing power. Instead, revenue generated by a specific project or source, such as tolls, fees, lease payments, or revenue generated by a public utility, is used to cover the debt service payments, including interest and principal.

In other words, the creditworthiness of revenue bonds hinges on the success and financial viability of the project or revenue source (e.g., airport, toll road). Because revenue bonds depend on specific revenue sources, they carry more risk compared to GO bonds and typically offer higher interest rates.

Private-Activity Bonds

Private activity bonds (PABs), or conduit bonds, are issued by state or local governments on behalf of private companies and nonprofits. These bonds are used to fund projects with both public benefits and private components, including affordable rental housing, economic development initiatives, healthcare facilities, private universities, airports, and transportation infrastructure.

The interest income earned from these bonds is generally exempt from federal income tax, making them an attractive investment for individuals seeking tax-exempt income. However, there are limitations on the total amount of private activity bonds issued in a state or local jurisdiction, and specific projects must meet certain eligibility criteria to qualify for tax-exempt status. Note that the tax-exempt status of private activity bonds may also change based on revisions to tax laws and regulations.

Zero-Coupon Bonds

Zero-coupon bonds, also known as zeros or discount bonds, are fixed-income securities that do not make periodic interest payments. They are issued at a deep discount and mature at their full face value, generating a return for investors through the difference between the purchase price and the redemption value.

Because zero-coupon bonds do not provide periodic income, they are often used as long-term investments or for specific financial planning purposes, such as funding your child’s education or for retirement.

The income generated from zero-coupon bonds is generally not subject to annual income tax. But, the bond accrues imputed interest (phantom interest) each year and your tax liability gets deferred until the bond matures or is sold.

Floating-Rate Bonds

Floating rate bonds, also known as variable rate bonds or floaters, are fixed-income securities whose interest payments adjust periodically based on changes in a specified benchmark interest rate. The interest rate usually gets determined by tying it to a short-term benchmark reference rate, such as the London Interbank Offered Rate (LIBOR) or the U.S. Treasury bill rate. The reference rate acts as the base rate, and the spread reflects the credit risk associated with the issuer.

The key feature of floating rate bonds is that the interest payments are reset at predetermined intervals, often every 3 to 6 months, based on the current level of the reference rate. This adjustment allows the bond’s interest payments to align with prevailing market rates, providing investors with a degree of protection against interest rate fluctuations.

When interest rates rise, the interest payments on floating-rate bonds increase, which helps to maintain the bond’s market value. Conversely, when interest rates fall, the interest payments decrease.

Refunded and Pre-Refunded Bonds

Refunded bonds have their principal amount held by the original issuer in a sinking fund, giving investors a sense of security. When interest rates decline or there is an opportunity to reduce borrowing costs, the issuer may refinance their outstanding bonds to take advantage of lower interest rates. The proceeds then get used to redeem or pay off the original bonds.

By refunding the bonds, the issuer can lower interest expenses and retire existing bonds. That reduces debt service costs and may free up funds for other projects or purposes. Investors who hold the refunded bonds receive the principal repayment from the new bond issuance.

Pre-refunded bonds are a specific type of refunded bond used to fund a callable bond at a later date. Corporations typically issue pre-refunded bonds to refinance their debt by exercising their right to buy back their bonds before maturity. These funds get invested in low-risk, interest-bearing securities, such as U.S. Treasury bonds or money market instruments.

Its purpose is to generate sufficient income from the invested funds to repay the original bonds when they come due. The pre-refunding process allows issuers to take advantage of favorable interest rate conditions before the original bond’s maturity.

Build America Bonds

Build America Bonds (BABs) were a type of taxable municipal bond program used to stimulate infrastructure investment and job creation during the Great Recession. The interest payments on BABs were subject to federal income tax, but they carried certain benefits for issuers and investors.

BABs offered issuers a lower borrowing cost compared to issuing traditional taxable bonds. The federal government provided a direct subsidy to the issuers via a refundable tax credit or a direct payment equal to a percentage of the bond’s interest cost, lowering the overall interest expense for the issuer.

For investors, BABs provided the opportunity to invest in municipal bonds with higher yields than tax-exempt bonds. The taxable nature of the interest payments meant that the yields on BABs were generally higher than comparable tax-exempt municipal bonds.

The Bottom Line

While municipal bonds are a popular investment due to their tax savings, it’s a good idea to understand the potential tax liabilities before investing. Otherwise, you may get hit by an unexpected tax bill that dips into your profits.

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