Death might be a certainty, but if you own municipal bonds, taxes aren't. Most munis are tax-exempt securities, which means that their interest isn't subject to federal income tax. However, just because they're generally tax-free doesn't mean that they always are. To get all of the tax benefits of owning them, you need to choose the right bond for where you live and for your tax situation.
Tax-Exempt Municipal Bonds
The federal government now gives up the ability to collect income tax on municipal bonds for a simple reason. Since the interest from the bonds is tax-free, the state and local governments and agencies that issue the bond get to pay below-market interest rates for their debt while still offering an at-market after-tax return to investors. This helps those government entities to save money on their borrowing costs.
Non-AMT Exempt Munis
Not every supposedly tax-exempt municipal bond is exempt from every type of federal tax, though. Certain types of municipal bonds -- called private activity bonds -- aren't exempt from the alternative minimum tax. The AMT is a special tax that many upper-middle income and upper-income taxpayers fall subject to. It eliminates most deductions and replaces them with a large AMT exemption and a simplified system of tax brackets. Another AMT provision is that you are required to pay tax on interest from municipal bonds issued by organizations taking on projects that could be private or governmental in nature. These private activity bonds are issued for such purposes as paying for airports, hospitals and some housing projects.
Munis and State Taxes
Municipal bonds are sometimes also state-tax exempt. Generally, you don't have to pay state income tax on interest that you earn from bonds issued by that state. California won't levy state income tax on California-issued bonds but will on Arizona-issued bonds, for example. This means that if you only buy bonds issued by the state in which you reside and pay taxes, you should be able to enjoy income that is free of federal and state tax.
Taxable Municipal Bonds
Municipal bonds are tax-free because the federal government agrees to make them so. Sometimes, though, the feds won't give a tax-free stamp to a bond. This turns it into a taxable municipal bond and happens in instances that include when a city borrows to put money back into its pension plan or when it borrows to build a stadium. When a muni bond isn't tax-free, it becomes similar to any other bond. This means that its before-tax yield is typically higher to match other taxable investments.
Trading Municipal Bonds
If you buy a tax-free municipal bond at its original issue and hold it until its maturity, you won't be taxed on it (barring the exceptions already discussed). This rule also applies to zero coupon municipal bonds that are sold at a discount and pay their interest in the form of a lump sum at maturity. If you buy and sell municipal bonds, though, you could be subject to capital gains tax. The IRS lets you earn interest tax-free, but if you make money by trading the bonds, that money will be taxable like the trading profits from just about any other investment.
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