When Are Municipal Bonds Taxable? - dummies

By Russell Wild

Will you never pay federal tax on a municipal bond? Never say never. In some very rare instances, the tax can grab you from behind and make you not want to wake up on the morning of April 15.

AMT tax on municipal bonds

The alternative minimum tax (AMT) 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 handpick your munis (and muni funds) to include only those that are exempt from the AMT.

In general, the interest on municipal bonds sold by state and local governments to finance very specific projects, as well as bonds issued by not-for-profit organizations and other “private activity” issuers such as airports and universities, is going to be included in the AMT. So if you are liable to pay the AMT, the tax-exempt status of these bonds will no longer be so entirely exempt.

If buying up these AMT-triggering bonds is not a liability concern, investing in them may make good sense. This type of muni tends to provide a slightly higher yield than do non-AMT munis.

Capital gains tax on municipal bonds

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.

If you pay $1,000 to pick up a muni selling at par, and you later sell it for $1,100, you very likely owe the government capital gains tax on your $100. If the buy and sell both occur within a one-year period, the tax hit will likely be 25 percent, 28 percent, or whatever your normal marginal income tax rate happens to be.

If your buy and sell span a period of more than one year, you need to pay long-term capital gains, which for most folk amounts to 15 percent.

(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 for, 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 loss, which is usually used to write off capital gains.

The fully taxable municipal bond

At first glance, a taxable muni seems about as sensible as a race horse running in a yoke, but in fact, taxable munis offer potential return comparable to investment-grade corporate bonds, and sometimes they may make for an excellent bond choice.

Taxable municipal bonds exist on the market because the federal government doesn’t give a break to the financing of certain activities that it perceives do not offer a significant benefit to the public. The funding of a new hockey stadium or the refunding of a municipality’s ailing pension plan are two examples of muni bond issues that would be federally taxable.

They barely existed a couple of decades ago but are becoming more and more popular.

Build America Bonds (known as BABs) are a special category of taxable muni. These bonds were issued in 2009 and 2010 as part of President Obama’s plan to revive the sagging economy. They allow local governments to raise capital, and the Treasury subsidizes 35 percent of the municipality’s interest costs.

Most of these bonds carry top ratings but tend to be especially volatile due to their lengthy maturity dates (sometimes as high as 30 years). If you have room only in your retirement accounts, and you want munis that pay about as much as corporate bonds, then a position in BABs or other taxable munis may actually make good sense.