What Is a Taxable Municipal Bond?
A taxable municipal bond is a non-tax-exempt fixed-income security issued by a local government, such as a city, county, or related agency, to finance projects that the federal government will not subsidize.
Key Takeaways
- A taxable municipal bond is a fixed-income security issued by a local government, such as a city, county, or related agency, to finance projects that the federal government will not subsidize.
- Taxable municipal bonds are typically used to fund projects that don't directly benefit the general public, which is why they are not granted tax-exempt status.
- Taxable municipal bonds are mainly issued to finance the shortfalls of state and local pension funds.
Understanding Taxable Municipal Bonds
Taxable municipal bonds are generally issued to finance an activity that is deemed not to provide a major benefit to the public. This means that the federal government will not grant a tax-exemption status to these projects.
A prominent feature of most municipal bonds is that they are tax-exempt. A municipal bond is a bond issued by local and state governments to fund projects for the betterment of the community, such as building schools, highways, and hospitals. A municipality may also issue a bond on behalf of a private company, which may be otherwise unable to obtain financing for the project.
These private activity bonds (PABs) attract private businesses, which results in more jobs in the area. An investor who buys a municipal bond is lending money to a municipality that promises to pay interest periodically until the bond matures, at which point the principal investment is repaid to the investor.
In order to encourage investors to purchase municipal bonds, the bonds are set up as exempt from federal taxes and some state taxes, depending on the situation and individual state laws. However, the tax-exempt status of municipal bonds is only granted if the projects funded from the proceeds of the issue provide a significant benefit to the community at large–in other words, the public.
While many investors will choose municipal bonds for the tax benefit despite the lower yield, there may be taxable bonds available that offer an after-tax yield that is higher, depending on the individual's current tax bracket.
Types of Taxable Municipal Bonds
The majority of taxable municipal bonds are issued to finance the shortfalls of state and local pension funds. 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. BABs were created under the American Recovery and Reinvestment Act (ARRA) of 2009 and, although taxable, have special tax credits and federal subsidies for either the bond issuer or holder. Taxable municipal bonds are popular among institutional investors and mutual funds that cannot take advantage of other tax breaks.
Requirements for Taxable Municipal Bonds
Interest from municipal bonds issued to finance projects with no obvious public benefits is taxable since the federal government will not subsidize the financing of these projects. Since income from such bonds is taxable in the hands of the investor, taxable municipal bonds offer risk-adjusted yields that are comparable to those available from other taxable entities, such as corporate bonds and other government agency bonds. The risks and benefits of each option will vary depending on a number of individual factors.
Some taxable municipal bond issues are exempt from state and, often, local taxes, in which case, investors who reside in the state of issuance are not taxed on their interest earnings at the state level. Thus, the effective yield that they earn on the bond will actually be higher than the stated yield.
FAQs
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.
What does taxable bond mean? ›
What Is a Taxable Bond? A taxable bond is a debt security (i.e., a bond) whose return to the investor is subject to taxes at the local, state, or federal level, or some combination thereof.
What is considered a municipal bond ____________? ›
Municipal bonds (munis) are debt securities issued by state and local governments. These can be thought of as loans that investors make to local governments, and are used to fund public works such as parks, libraries, bridges and roads, and other infrastructure.
What is a municipal bond quizlet? ›
A municipal bond is. a bond issued by a state or local government or municipality to finance such improvements as highways, state buildings, libraries, parks, and schools.
What is the difference between a taxable bond and a municipal bond? ›
Tax Liability: Unlike municipal bonds, the interest earned on taxable bonds is subject to federal, and possibly state and local, income taxes. This reduces the net income for investors, particularly those in higher tax brackets.
What are examples of municipal bonds? ›
Municipal bonds come in two varieties: General obligation and revenue bonds. General obligation bonds are used to finance public projects that aren't linked to a particular revenue stream. Revenue bonds, by contrast, are used to finance public projects with the potential to generate revenue.
What is the downside of municipal bonds? ›
Municipal bonds, like all bonds, pose interest rate risk. The longer the term of the bond, the greater the risk. If interest rates rise during the term of your bond, you're losing out on a better rate. This will also cause the bond you are holding to decline in value.
How do municipal bonds work? ›
By purchasing municipal bonds, you are in effect lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or “principal.” A municipal bond's maturity date (the date when the issuer of the bond repays the principal) may be ...
How much do municipal bonds pay? ›
AAA RATED MUNI BONDS
| Issue | maturity range | today |
|---|
| national | 10 year | 2.75 |
| national | 20 year | 3.60 |
| national | 30 year | 3.95 |
Two broad classes of munis
General obligation, or GO, bonds are backed by the general revenue of the issuing municipality, while revenue bonds are supported by a specific revenue source, such as income from a toll road or sewer system.
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.
How often do municipal bonds pay interest? ›
Generally fixed rate municipal bonds pay interest on a semiannual basis such as on June 30 and December 31 of each year. However, municipal bonds can have different payment periods and dates, such as an annual payment.
What happens when a municipal bond is called? ›
An issuer may choose to call a bond when current interest rates drop below the interest rate on the bond. That way the issuer can save money by paying off the bond and issuing another bond at a lower interest rate. This is similar to refinancing the mortgage on your house so you can make lower monthly payments.
What happens to municipal bonds? ›
Municipalities generally take responsibility for parks and recreation services, police and fire departments, housing services, emergency medical services, municipal courts, transportation services (including public transportation), and public works (streets, sewers, snow removal, signage, and so forth).
Who holds municipal bonds? ›
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.
How many types of municipal bonds are there? ›
Two broad classes of munis
General obligation, or GO, bonds are backed by the general revenue of the issuing municipality, while revenue bonds are supported by a specific revenue source, such as income from a toll road or sewer system.
Which municipal bonds are tax-exempt? ›
Municipal Bonds
Most bonds issued by government agencies are tax-exempt. This means interest on these bonds are excluded from gross income for federal tax purposes. In addition, interest on the bonds is exempt from State of California personal income taxes.
What is the difference between taxable munis and tax-exempt munis? ›
The main difference between a taxable municipal bond and a tax-exempt muni is that taxable munis pay interest income that's subject to federal and state income taxes, whereas tax-exempt munis pay interest income that's generally exempt from federal and state income taxes.
