What Are the Tax Benefits of Municipal Bonds?

By Maurie Backman Markets Fool.com

While bond investments aren't always the most expedient way to grow your wealth, the good thing about bonds is that when all goes well, they provide a steady stream of income with far less risk than what stock investments entail. And though many investors are drawn to corporate bonds -- meaning, those issued by large companies -- municipal bonds have become a more popular choice among investors because of the tax benefits involved.

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Municipal bonds are those issued by states, cities, or counties to fund public projects. While there are several benefits of municipal bonds, their primary advantage is that the interest they pay is tax-free at the federal level. And if you buy municipal bonds issued by your home state, you can avoid state and local taxes in addition to getting a federal tax break. If you're looking to lower your tax burden, it pays to see whether municipal bonds belong in your portfolio.

Tax-free interest

Whenever you receive interest on a corporate bond, those payments are taxed as ordinary income. So if you typically lose 25% of your income to taxes, you'll lose 25% of your interest payments as well.

Municipal bonds work differently in that they're automatically exempt from federal taxes, and if you buy bonds issued by the state you live in, you can avoid state and local taxes as well. So while a $1,000 interest payment from a corporate bond might only effectively put $750 in your pocket, if you receive a $1,000 municipal bond interest payment, you'll get to keep the whole thing. If you're in a high tax bracket or need a way to reduce your taxable income, you might consider adding municipal bonds to your investment mix.

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That said, corporate bonds typically offer interest rates that are higher than those of comparably rated municipal bonds, and so in some cases, it could make more sense to take a hit tax-wise in exchange for a higher yield. If you're not sure whether to opt for a corporate bond versus a municipal bond, it helps to calculate what's known as the tax-equivalent yield. The tax-equivalent yield is the pre-tax yield that a corporate, or taxable, bond needs to offer to equal the yield of a tax-free municipal bond.

Imagine your federal tax bracket is 25% and you're looking at a municipal bond paying 5% interest. If you find a corporate bond yielding 6.67%, you'd essentially come away with the same amount of money after paying your taxes. The best way to use this formula is to make sure you're looking at two bonds with roughly the same rating. The lower a bond's rating, the more risk it entails, so that should factor into your investment decision as well.

No tax breaks on investment gains

While the interest you collect from municipal bonds is exempt from federal (and sometimes other) taxes, gains on the sale of municipal bonds are a different story. If you sell your municipal bonds at a price that's higher than what you paid for them, you'll still be liable to pay capital gains taxes. The extent to which you're taxed will depend on how long you hold your bonds before selling them. If you hold them for a year or less, you'll be taxed at the short-term capital gains rate, which is what you pay on ordinary income. If you hold your bonds for at least a year and a day before selling, you'll be taxed at the more favorable long-term capital gains rate. Either way, expect to fork over some money to the IRS if you sell municipal bonds at a profit.

Municipal bonds and Social Security taxes

While it's true that municipal bond interest is always tax-exempt, it could come back to bite you with regard to your Social Security benefits. While some beneficiaries don't wind up paying taxes on Social Security, the IRS might take a share of your benefits if your additional income is high enough. To figure out whether you'll need to pay taxes on Social Security, you'll have to calculate your provisional income as follows:

  • First, take your total income not including Social Security
  • Then, add in your tax-free interest payments for the year, which include municipal bond payments
  • Finally, add in 50% of your Social Security benefit

If you're a single tax filer and your total falls between $25,000 and $34,000, you could be taxed on up to 50% of your benefits. The same holds true if you're a couple filing jointly and that number falls between $32,000 and $44,000. Additionally, if your provisional income exceeds $34,000 as a single filer or $44,000 as a couple filing jointly, you could be taxed on up to 85% of your Social Security benefits.

As you can see, collecting interest from municipal bonds could push your income level into a taxable threshold with regard to Social Security. While municipal bonds can be a smart investment choice for investors of all ages, if you're a retiree, you'll need to consider the consequences of adding them to your portfolio.

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