The federal government grants tax-exempt status to municipal bonds in most cases. This lowers the cost of borrowing for state and local governments and makes these bonds attractive to those in higher tax brackets. Specifically, interest paid by municipal bonds is usually not subject to income tax, though capital gains taxes may still apply. Certain tax-exempt bonds bought before May 1, 1993, also receive a tax advantage.
The primary advantage of municipal bonds over corporate bonds is the lack of income tax for most taxpayers. This means that the after-tax income provided by a tax-exempt bond is higher than that provided by corporate bonds for those in higher tax brackets. For example, for someone in the 35 percent marginal income tax bracket, a municipal bond earning an interest rate of 5 percent has a taxable equivalent yield of 7.69 percent. That means a corporate bond must generate a yield of 7.69 percent to generate the same amount of after-tax income for that taxpayer as the 5 percent municipal bond.
Exceptions to Tax-Free Status
Certain municipal bonds, called "private activity bonds," are not tax exempt under alternative minimum tax rules. These rules apply to some taxpayers with higher incomes or who take a lot of deductions. Some deductions are disallowed under alternative minimum tax rules, and income from private activity bonds becomes taxable.
Capital Gains Taxes
Both corporate and municipal bonds generate capital gains and losses on trades, based on the bond price. Gains are taxable, either as long-term or short-term gains, while losses can cancel out capital gains, plus up to $3,000 per year in ordinary income.
Market Discount Bonds
If you buy bonds at a discount to par value -- that is, for less than $1,000 per bond, in most cases, you must declare any gains attributable to the discount as interest, rather than as capital gains. However, tax-exempt bonds purchased prior to May 1, 1993, are not subject to this rule. The rule applies to corporate bond issues and other taxable bonds issued after July 18, 1984, however.
- Jupiterimages/BananaStock/Getty Images