Federal tax-exemption of municipal bonds. The interest income earned from most municipal bonds is exempt from all federal income taxes regardless of your tax bracket. This is the most significant benefit of municipal bonds and it is a characteristic unique to municipal bonds. Not even US Treasuries offer income that is free from federal income taxes.
- EXAMPLE: If you buy $10,000 worth of municipal bonds with a 4% coupon, the $400 you receive every year is tax-free.
Additionally, municipal bonds can be free of state income taxes as well. In most states, the interest income from municipal bonds issued by an issuer in the state is free from state income taxes in that state. For instance, a resident of Los Angeles can buy any municipal bond issued by a municipality in California and will not have to pay California state income taxes on the interest income. However, if the same LA resident purchased a Texas municipal bond, the income would still be tax-free on a federal level, but the California resident would owe California state income taxes since it is a bond issued out-of-state. (We will cover state taxation rules in a later chapter.)
Other tax exemptions can include being free of city income taxes as well in cities like New York City when qualifying municipal bonds are purchased. Most municipal bond interest is also free of AMT or the alternative minimum tax.
As a result, the higher the investor's tax bracket, the benefit of the tax-free income becomes greater. A person in the 35% tax bracket receives more benefit from the tax savings than does a person in the 25% tax bracket. To compare the tax-free interest from municipal bonds to other taxable interest-bearing investments, people often compare the "taxable-equivalent yield" of a tax-exempt investment to a taxable investment.
Taxable-equivalent yield is simple to understand as a concept. Let's say that a bank CD is paying 6% and a municipal bond issued in your state yields 4%. On an investment of $10,000, the bank CD earns $600 in annual interest while the municipal bond earns $400. However, a person in the 35% tax bracket must pay 35% of the $600 in federal income taxes, which is $210 in taxes resulting in $390 after taxes. The municipal bond in this case offers a better taxable-equivalent yield earning $400 tax-free annually. Additionally, the interest from the CD will also be taxed at the state-level whereas the municipal bond may be free of state income taxes as well.
For investors in high-tax states such as California and New York, the benefits of tax-free bonds are even greater than for residents of states without any state income tax such as Texas or Florida. We'll cover state taxation in another chapter.
[NOTE: There are such things as taxable municipal bonds — it will be described as taxable when you are purchasing the bonds. If a municipal bond you are considering says taxable, this means that it is taxable on the federal level.]