Tax Effects on Municipal Bonds

by Ciaran John

Municipal bonds provide investors with tax-free income because the federal government exempts most types of municipal bonds from federal income tax. You do have to pay state income tax on municipal bond interest payments if you buy bonds from another state, but you pay no income tax on municipal bonds issued by government entities based in your own state. Tax increases and decreases have an impact on the value of previously issued bonds, as well as the yields of newly issued bonds.

Federal Tax

When you buy a bond, the bond issuer agrees to pay interest on the debt until the end of the bond term, and at that point you get your principal back. However, you can sell municipal bonds to other investors before the bond matures. Municipal bonds have lower yields than taxable bonds, but if federal income taxes rise, the after-tax yield on other types of bonds decreases, which makes municipal bonds more attractive. Consequently, you can often sell municipal bonds for a premium when taxes are rising. When federal income tax rates decrease, the after-tax yield on taxable bonds increases and this makes municipal bonds less attractive, and can cause the current market value to drop.

State Tax

If you own bonds issued within your state, a state tax hike has no impact on your taxable income since these bonds are tax exempt. However, you do have to pay more in terms of state taxes on the interest you earn on municipal bonds that issued in other states. This means that after tax increases in your state, bonds issued in other states suddenly become less valuable to you and other investors in your state. Consequently, fewer people buy the bonds and this drives down the price. The government in the other state must raise rates to entice new investors. The availability of newly issued high-yield bonds, drives down the prices of older bonds even further.

Alternative Minimum Tax

Some high earners have to pay the federal alternative minimum tax (AMT), rather than ordinary income tax. When you calculate your taxable liability under the AMT, you cannot deduct all of the expenses that you can deduct when you calculate income tax. If your AMT liability exceeds your income tax liability then you have to pay the AMT. Some municipal bonds that finance joint public and private ventures are exempt from income tax, but are not exempt from the AMT. If federal tax rates decrease, then more people find themselves having to pay the AMT. This makes many municipal bonds less attractive to investors, and causes the market value of the bonds to drop. Therefore, the AMT has a direct impact on the value of certain types of municipal bonds.

Other Considerations

Some municipalities use bonds to finance projects such as the building of sports stadiums and other projects that from a federal tax perspective do not provide a significant benefit to the community. Such bonds are not exempt from federal taxation. The interest payments on municipal bonds are usually tax exempt, but the capital gains on the bonds are not. You must pay short-term capital gains tax on bonds that you hold for a year or less, and long-term capital gains tax on bonds you hold for more than one year. Therefore, if you buy a bond at a discount, you may end up with a hefty tax bill when it reaches maturity. Conversely, you may get a tax write off if you buy a bond at a premium.

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