Paying Taxes on Municipal Bonds - dummies

Paying Taxes on Municipal Bonds

If you are buying municipal bonds, then there are two taxes that may rear their heads on April 15: the AMT tax and capital gains taxes.

  • The AMT tax: The alternative minimum tax is a federal tax that exists in a parallel universe, which you enter unwillingly when you make a fair chunk of change, claim too many exemptions, or take too many deductions.

    Ask your tax guru if you are likely to be smacked by AMT at any point in the near future. If so, you may want to hand-pick your munis (and muni funds) to include only those that are exempt from the AMT.

  • Capital gains taxes: If you buy a security at a certain price and then sell it at a higher price, that’s a good thing! But you may be subject to pay capital gains tax to the IRS . . . even if the security you sold is a tax-exempt municipal bond. (The tax rules governing municipal zero-coupon bonds bought at a discount and then sold at a lesser discount or a premium can be complicated; talk to your tax advisor.)

    What pertains to individual bonds also pertains to municipal bond mutual funds. Sell your shares for more than you purchased them, and you’ll have to pay capital gains. Of course, if you sell at a loss, whether a bond or a bond fund, you may then declare a capital-gains tax loss, which is usually used to write off capital gains.