How Are Municipal Bonds Taxed? (2024)

FAQs

How Are Municipal Bonds Taxed? ›

Income from bonds issued by state, city, and local governments (municipal bonds, or munis) is generally free from federal taxes. * You will, however, have to report this income when filing your taxes. Municipal bond income is also usually free from state tax in the state where the bond was issued.

The only real disadvantage of municipal bonds is that they carry relatively low interest rates compared to other types of securities. This is particularly true when the economy is strong and interest rates for Treasury bills and CDs rise.

A municipal bond, also known as a muni, is debt security used to fund capital expenditures for a county, municipality, or state. Municipal bonds are commonly tax-free at the federal level but can be taxable at state or local income tax levels or under certain circ*mstances.

Capital gains on municipal bond investments are taxable as short- or long-term capital gains, depending on how long you have held the investment. Income from certain private-activity bonds must be reported as taxable income if you are subject to the alternative minimum tax.

If you sit in the 35% income tax bracket and live in a state with relatively high income tax rates, investing in municipal bonds (munis, for short) will likely be a better option than taxable bonds. Alternatively, if your income is in the 12% tax bracket, you may want to steer clear of municipal bonds.

Municipal Bonds in an IRA

Since the interest and capital gains in an IRA are already tax-exempt, there isn't any benefit to holding munis in an IRA.

Municipal bonds had a tough 2022. But 2023 is looking much better and that makes us optimistic about the potential benefits of considering this asset class for client portfolios. Inflation has begun to moderate, and yields declined sharply in January, which supported the municipal bond market to start the year.

In other words, as the price of a bond goes down, the yield goes up and vice versa. Thus, when interest rates rise, a bond's price usually declines because an investor can earn a higher yield with another bond. Conversely, when interest rates fall, the bond's price usually rises.

Are municipal bonds a good investment? ›

Muni bonds are high-quality investments that may be well positioned to weather potential recessions. Talk to your financial professional to see if muni bonds make sense for your investment portfolio.

On the plus side, highly-rated municipal bonds are generally very safe investments compared to almost any other investment. The default rate is tiny. As with any bond, there is interest rate risk. If your money is tied up for 10 or 20 years and interest rates rise, you'll be stuck with a poor performer.

You can skip paying taxes on interest earned with Series EE and Series I savings bonds if you're using the money to pay for qualified higher education costs. That includes expenses you pay for yourself, your spouse or a qualified dependent. Only certain qualified higher education costs are covered, including: Tuition.

A major benefit of municipal bonds, or "munis," is that the interest they pay is generally exempt from federal income taxes. They're also generally exempt from state income taxes if the issuer is from the investor's home state.

Key Takeaways. Both certificates of deposit (CDs) and bonds are considered safe-haven investments with modest returns and low risk. When interest rates are high, a CD may yield a better return than a bond. When interest rates are low, a bond may be the higher-paying investment.

After a long and difficult 2022 year to date, the municipal bond market should fare better in 2023. We think that rates will be volatile due to Fed policy and concerns about economic growth. However, for the first time in a long time, investors can finally earn attractive yields without having to take on undue risk.

General obligation (GO) bonds are funded directly by tax revenues. They are the safest type of municipal bond, but they often have the lowest interest rates.

Although general obligation bonds account for only about a quarter of the muni bond market, they tend to get the most attention. Historically, GO bonds were considered the more secure of the two options, because they are backed by the full faith and credit of the municipal government.

Investors may experience mid-single digit returns in 2023 as we begin the year with tax-free AAA muni yields between 2.50% and 3.50% and see the potential for a stable or potentially lower interest rate environment ahead.

If you are investing for income, either municipal bonds or money market funds will pay you interest. Just know that bonds can lose value and money market funds most likely won't.

Are municipal bonds very risky investments? ›

While default risk is low, muni bonds are subject to interest rate risk, or the risk that rising rates will lead to falling prices. This is even more true for investors in bond funds and exchange-traded funds (ETFs) that invest in munis.

Municipal bond issuance was just $396.7 billion in 2022, according to Refinitiv Lipper and JPMorgan data, well below most industry forecasts from the beginning of the year and a 20% decrease from the $498.6 billion in 2021. That decline in new supply has supported pricing for existing bonds.

Higher Coupon Rates

As always, longer-term bonds still carry higher rates than short-term securities because of the increased inflation and credit risk. However, long-term municipal bonds, especially general obligation bonds, can be extremely safe if issued by a highly-rated municipality.

During periods of inflation, if the inflation rate was greater than the coupon rate, it would be possible to lose money by investing in a municipal bond, because the interest earned on the bond would be less than the value the money was losing through inflation.

The bonds were purchased before 2019 and still held in 2020. As part of its moves to shore up the markets during the onset of COVID-19, the Fed bought $6 billion worth of municipal bonds.

Interest income from treasury and corporate bonds, on the other hand, is taxed federally. For this reason, an investor may prefer a municipal bond over a treasury bond—even if the treasury bond has a higher yield—because the municipal bond ends up having a higher after-tax yield.

Investment minimums for municipal bonds are typically $5,000 per bond, so an investor with limited funds to invest and who is seeking exposure to a wide range of maturities, sectors and credits might consider a mutual fund or an ETF.

However, investors who sell their bonds prior to maturity will only receive the interest due on the bond until the date of the sale. They will lose all rights to the interest that would have accrued between the date of the sale and the bond's maturity date.

The current yield is ~4.18%.

The Treasury Building. One of the best deals for savers now are Treasury Series I savings bonds now paying a 7.12% interest rate. The savings bonds, available electronically through TreasuryDirect, pay interest based on the inflation rate, as measured by the consumer price index.

What is the yield to worst on municipal bonds? ›

On a corporate or muni bond (or any debt paying a coupon), the yield to worst is the lowest yield that a buyer can expect among the reasonable alternatives, such as yield to maturity, yield to call, and yield to refunding.

Municipal bonds, often called "munis," offer investors a way to generate tax-free income in the form of interest payments from state and local governments. Municipal bonds help finance projects such as roads, schools and other public works efforts.

Who buys municipal bonds? About 72 percent of bonds are owned by individuals directly or through mutual funds and the like. About 25 percent of bonds are owned by businesses, primarily property and casualty and life insurance companies, but also banks.

Bond prices decline when interest rates rise, when the issuer experiences a negative credit event, or as market liquidity dries up. Inflation can also erode the returns on bonds, as well as taxes or regulatory changes.

Taxation of municipal bonds

Income from bonds issued by state, city, and local governments (municipal bonds, or munis) is generally free from federal taxes. * You will, however, have to report this income when filing your taxes.

You'll likely buy municipal bonds from a bond dealer, broker or bank like Ally Invest. If you want to avoid investing directly in the bond market, you can also invest in bonds through mutual funds or ETFs (exchange-traded funds). Both of these invest in several underlying holdings.

The 1099-INT will only come when someone cashes the bond or the bond matures. The interest will be reported under the name and Social Security Number of the person who cashes the bond or who owns it when it matures. The 1099-INT will include all the interest the bond earned over its lifetime.

They are still taxable. The interest income of the savings bond will be taxed to the bond's owner—i.e., the recipient of the gift—when the bond matures and is redeemed for cash (or the owner will be taxed each year if they elect to report the interest income annually).

Treasury bonds and Series I bonds (savings bonds) are also tax-efficient because they're exempt from state and local income taxes. 1112 But corporate bonds don't have any tax-free provisions, and, as such, are better off in tax-advantaged accounts.

Types of Taxable Municipal Bonds

Other situations where taxable municipal bonds may be issued include financing local sports facilities, funding infrastructure-related repairs or investor-led housing, or refinancing debt. Build America Bond (BABs) are an example of taxable municipal bonds.

At what income level do municipal bonds make sense? ›

If you sit in the 35% income tax bracket and live in a state with relatively high income tax rates, investing in municipal bonds (munis, for short) will likely be a better option than taxable bonds. Alternatively, if your income is in the 12% tax bracket, you may want to steer clear of municipal bonds.

How rare are municipal bond defaults? Cumulative default rates for investment-grade municipal bonds total 0.09% over ten-year periods, on average. This compares with 2.17% for the global corporate market—well over twenty times that of municipals according to Moody's data as of December 31, 2021.

Municipal bonds had a tough 2022. But 2023 is looking much better and that makes us optimistic about the potential benefits of considering this asset class for client portfolios. Inflation has begun to moderate, and yields declined sharply in January, which supported the municipal bond market to start the year.

If you own municipal bonds, you're likely well aware that they've had a tough year, as the Federal Reserve has hiked interest rates sharply. Rising interest rates negatively impact the price of bonds, including muni bonds; this prompts many investors to sell, which puts further pressure on bond prices.

Safety: Municipal bonds are considered a relatively safe fixed-income investment. GO bonds are usually considered safer than revenue bonds, as a municipality can raise taxes to cover outstanding debt obligations, whereas revenue bonds are subject to the earnings made by that particular project.

One of the major risks associated with municipal bonds is the possibility that short-term yields will rise. This means other bonds coming on the market will pay a higher rate to bond owners, and your bond will be seen as less valuable. This can cause the price of your bond to drop.

Some of the disadvantages of bonds include interest rate fluctuations, market volatility, lower returns, and change in the issuer's financial stability. The price of bonds is inversely proportional to the interest rate. If bond prices increase, interest rates decrease and vice-versa.

Investors may experience mid-single digit returns in 2023 as we begin the year with tax-free AAA muni yields between 2.50% and 3.50% and see the potential for a stable or potentially lower interest rate environment ahead.

Muni bonds tend to be high-quality investments.

The five-year cumulative default rate for muni bonds was only 0.08% from 1970-2021. Global corporate bonds defaulted at 6.8% over the same time frame. What's more, many municipalities were bolstered by direct federal aid during the pandemic.

Can you lose principal on muni bonds? ›

Can You Lose Money on Municipal Bonds? You also could lose money on muni bonds if you are forced to sell the bonds on the secondary market at the wrong time. The price you get will be determined by the total dollar amount of the remaining interest payments due, factoring in the prevailing rates available on new issues.

U.S. interest rates have been low for some time. If they move higher, investors who hold a low fixed-rate municipal bond and try to sell it before it matures could lose money because of the lower market value of the bond.

Municipal bonds aren't bulletproof, but they are one of the safest investment vehicles you will find. They also offer substantial tax advantages and are very liquid when held as ETFs. These benefits lead to lower returns, but those returns will be tax-free.

Buy Bonds during a Market Crash

Government bonds are generally considered the safest investment, though they are decidedly unsexy and usually offer meager returns compared to stocks and even other bonds.

The value of fixed income securities will fluctuate and, upon a sale, may be worth more or less than their original cost or maturity value. Bonds are subject to interest rate risk, call risk, reinvestment risk, liquidity risk, and credit risk of the issuer.

U.S. Treasury bonds are considered one of the safest, if not the safest, investments in the world. For all intents and purposes, they are considered to be risk-free. (Note: They are free of credit risk, but not interest rate risk.) U.S. Treasury bonds are frequently used as a benchmark for other bond prices or yields.