One of the attractions of municipal bonds is tax savings. You can create an income without paying income tax.
However, though municipal bonds may be called “tax-free,” make sure you understand all of the tax implications. There are different kinds of tax treatments for the different ways you can make money on municipal bonds. Also, taxation can depend on the purpose of the bond in terms of who will benefit from the project that is being funded.
Tax-free status refers to how interest payments are treated. If the municipality issuing the bond normally charges income tax, it will not tax interest income on its bonds. You won’t pay tax to the municipality.
Many states do not tax income from municipal bonds issued in the state, but this is not true of all states. If your state has an income tax, you could be subject to tax on your municipal bond interest. Contact your state tax office to find out the specific regulations where you live.
Municipal bond interest is generally free from federal taxation. However, this applies only to bonds issued for public projects—ones that benefit the public. If a bond only benefits a private entity, it can be taxed at the federal level. The term “municipal bond” is sometimes used loosely. A bond may be called “tax free” because of a tax deal with a local private entity. It could still be subject to federal tax.
If you sell your bond for a profit, you will pay capital gains tax. This is a tax on the profits from buying and selling investment instruments. A tax-free municipal bond may offer interest income that is tax-free for federal income taxes, but you will still have to pay capital gains tax if you sell the bond to a third party for more than you paid for it.
If you sell a bond for the same price you paid for it, you do not pay any tax on the transaction.
Some municipalities will allow you to redeem your bond before it matures. In other words, the issuer will buy the bond back from you. If you redeem the bond for more than you paid for it, you will have to pay capital gains on the profit, even though you technically did not sell it. For tax purposes, the Internal Revenue Service counts a redemption as a sale.
Just because a bond is called “tax free” does not mean that you are completely free of all tax liability. Do your due diligence and make sure that your particular situation qualifies you for tax-exempt status. If you live in the city or town where the municipal bond is issued and plan to collect interest payments without selling the bond, you might be in a good position to benefit from municipal bonds.
If you plan to profit from selling the bond, or if it is a bond for the benefit of a private entity, make sure you understand that you could pay taxes.