The Key Benefit of Municipal Bonds: Tax-Free Interest


August 20, 2011

By:

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.]

Login to your account

Email address:
Password:

Become a member

Register for a MunicipalBonds.com account to get access to a whole new way of tracking, analyzing, and researching bonds.

   Keep track of bonds you own
   Get ratings from S&P for all rated municipal bonds
   View issue history reports
   Access our price archives
...And much more

Register now »

We are providing certain data supplied to us by the Municipal Securities Rulemaking Board ("the Service") without warranties or representations and on an "as-is" basis. WE HEREBY DISCLAIM ALL REPRESENTATIONS AND WARRANTIES (EXPRESS OR IMPLIED), BUT NOT LIMITED TO, WARRANTIES OF MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE REGARDING THE SERVICE. You shall bear all risk, related costs and liability and be responsible for your use of the Service.

The transaction data provided through the Real-Time Transaction Subscription Service represents municipal securities transaction data made available by brokers, dealers, and municipal securities dealers to the MSRB and related information. Such transaction data and/or related information may not exist for all municipal securities and may not be required to be submitted to the MSRB for certain types of municipal securities transactions. The MSRB does not review transaction data submitted by submitters for accuracy, completeness or any other purpose, and does not warrant or guarantee the accuracy of any such transaction data and/or related information.

The MSRB, its officers, directors, employees, agents, consultants, and licensors shall not be liable or responsible to you or anyone else for any losses, injuries, damages, costs, expenses or claims caused by, arising out of or relating to the following: (a) acts, omissions, occurrences or contingencies beyond their control; (b) service interruptions or performance failures, such as those that result from the use of telecommunications facilities that are outside of their control, including the Internet: (c) negligence, gross negligence or willful misconduct in procuring, compiling, interpreting, editing, writing, reporting or delivering any of the content and material; (d) lost, stolen, late, corrupted, misdirected, failed, incomplete or delayed transmissions by anyone using the Service, including, but not limited to, any technical malfunctions, human error, computer viruses, lost data transmissions, omissions, interruptions, deletions, defects, hyperlink failures or line failures of any telephone network, computer equipment, software or any combination thereof; (e) damage to your computer systems, equipment, software, data or other tangible or intangible property resulting from or sustained in connection with your use of the Service; and/or (f) any disruption of business, lost sales or lost profits or any punitive, exemplary, indirect, special, incidental, or consequential damages associated or in connection with, resulting from or arising out of any use of the Service or the content and material in the Service.

The MSRB and its officers, directors, employees, agents, consultants, and licensors shall have no liability in tort, contract, or otherwise (and as permitted by law, product liability) to you or anyone else for any reason associated or in connection with, resulting from or arising out of your use of the Service. The MSRB, its officers, directors, employees, agents, consultants, and licensors make, and have made, no recommendations regarding any of the securities or other investment vehicles, referred to or described in the Service.

The Service is reproduced by permission of the MSRB under a non-exclusive license. The MSRB accepts no responsibility for the accuracy of the reproduction of the Service or that Service is current.