Taxation of Municipal Bond ETFs

by Ciaran John

Government entities borrow money from investors by issuing bonds. Bond issuers usually make interest payments at least twice a year and some bondholders rely on this interest payments as a form of income. Municipal bonds are typically exempt from federal income tax and you can enjoy this tax free income even if you buy an exchange traded fund (ETF) that contains municipal bonds.

Exchange Traded Funds

Exchange traded funds, like mutual funds, contain an array of different securities. However, ETFs are traded like stocks rather than mutual funds. This means that you can buy and sell ETFs on the secondary market and the shares in these funds are subject to constant price fluctuations. In contrast, you can only buy mutual fund shares after the stock market closes and shares are bought from or sold to the mutual fund company. You cannot sell mutual fund shares to other investors. If an ETF contains municipal bonds, then the interest payments are disbursed to investors. Some ETFs make monthly dividend distributions.

Federal Tax

The federal government does not tax interest payments on municipal bonds as long as the bonds finance projects that are for the greater good of the public. Tax-exempt bonds include bonds used to finance schools, roads and the emergency services. Bonds issued to build a particular team's sports stadium and other similar types of projects are not normally exempt from federal taxes. If you own share in an ETF that holds tax-exempt bonds, then you pay no federal income tax on your dividends since the dividends consist of interest payments. If the fund holds both taxable and tax-exempt bonds, then your dividends are partially taxable but the fund company must provide you with information pertaining to your tax liability.

Other Taxes

While Municipal bonds are ETF bond funds are exempt from federal income tax, you still have to pay state income tax on your dividends. However, you do not have to pay tax on ETF municipal bond fund dividends if the fund only holds bonds that were issued in the state where you live. If you live in a state that has no income tax, then a tax-exempt ETF fund would provide you with tax free income. However, some high earners have to pay the federal alternative minimum tax (AMT) rather than regular income tax. If this applies to you, you have to pay AMT even on otherwise tax-exempt income. Therefore, consult a financial professional to determine whether you are subject to AMT before you invest.

Capital Gains

You may not have to pay income tax on your dividends but capital gains from ETF municipal bonds funds are taxable. You have to pay ordinary income tax on your gains if you sell your ETF shares for profit within 12 months of purchase. You pay the long-term capital gains tax on realized gains on shares that you held for over one year. You also pay long-term or short-term capital gains tax on dividends that the fund disburses whenever bonds within the fund are sold for profit, as the fund has to pass on these earnings to shareholders.

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