States and local governmental entities issue municipal bonds to raise cash for projects. If the projects serve the public good, the bonds are ruled tax-exempt and you do not have to pay federal income tax on them. Other municipal bonds serve private needs, like building a sports stadium, and are not tax-exempt. Tax-exempt munis are also tax-free to residents of the issuing state. Municipal bond ETFs specialize in delivering tax-free interest income to shareholders.
An ETF is a basket of securities, in this case municipal bonds, that trades as shares on a stock exchange. These ETFs may be tied to a particular index of municipal bonds, but also may be organized to produce tax-free income to residents of a state that levies an income tax. Triple-tax locales like New York City motivate muni ETFs that offer tax-free income at the city, state and federal level. Unlike mutual funds, which create and cancel shares as needed, the number of shares issued by an ETF is fixed and priced according to supply and demand on the stock market floor.
Interest income from muni ETFs that hold only tax-exempt bonds is free from federal tax. These ETFs may also offer tax-free interest income to residents of states that issue tax-free munis held by the ETF portfolio. Some federal and state taxes may be due if a muni ETF contains a mix of tax-free and taxable interest. ETF management companies issue forms every year to shareholders detailing any federal tax obligations. The forms will also include information about how much of your interest income is tax-free in your state. Any taxable interest is taxed at the investor’s marginal rate.
Muni ETFs do not shield against capital gains taxes, which apply to trading profits rather than interest income. Long-term capital gains, for assets held for over one year, are taxed at the 20 percent rate on individuals earning $400,000 and couples earning $450,000. Lower rates, either 15 percent or 0 percent, apply to lower-earners, depending on their tax brackets. Short-term capital gains are taxed at the investor’s marginal rate. Muni ETFs can generate capital gains in two ways. First, investors realize capital gains or losses when they sell shares. If they held the shares for over a year, long-term rates apply. Secondly, an ETF realizes a gain or loss when it sells bonds from its portfolio or a bond matures. If the ETF held the bonds for over one year, the gains or losses are classified as long-term.
The year 2013 saw the introduction of a 3.8 percent Medicare tax that affects individual taxpayers with modified adjusted gross incomes of at least $200,000 and couples with MAGIs of $250,000 and above. The tax is levied on investor income or the amount of MAGI that exceeds the noted thresholds. Investor income for purposes of the Medicare tax includes all interest, including that from tax-exempt munis. It also includes dividends, capital gains, rents, royalties and annuities -- in short, all passive income.
Alternative Minimum Tax
Tax-free interest from muni ETFs may not escape taxation if the investor falls within the AMT guidelines. These guidelines are meant to extract taxes from well-heeled citizens who would otherwise avoid most or all taxes. The AMT rules are very complicated, and you should consult with your financial advisor or accountant to gauge your exposure.
- Investing in Municipal Bonds: How to Balance Risk and Reward for Success in Today’s Bond Market; Philip Fischer
- The Fundamentals of Municipal Bonds; SIFMA
- Bond Investing For Dummies; Russell Wild
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