One of the advantages of municipal bonds is that they are free of state income taxes. As a general rule in most states, if the bonds are issued in a particular state, they are exempt from that state’s income taxes.
For instance, a bond issued by a municipality in New York will be exempt from New York state income tax. Since there are 50 states plus D.C. and territories such as Puerto Rico, the U.S. Virgin Islands, and Guam, it is not possible for us to go over examples involving each state. As such, we’ll go over some basic concepts and cover only certain states in this article.
First, having the benefit of not paying state income taxes on top of not having to pay federal income taxes increases the taxable-equivalent yield. The higher a state’s income tax, the greater the likelihood of in-state buyers buying their state’s bonds. Conversely, states without an income tax have to offer slightly higher yields to attract both in-state and out-of-state buyers.
Bonds From U.S. Territories
No state can tax bond interest issued by U.S. territories such as Puerto Rico, Guam, and the U.S. Virgin Islands. A resident of any state can buy bonds issued by the territories and have the interest tax-exempt from their state’s income taxes.
States with No Income Taxes
The states listed below have no income taxes, which means a couple of things:
If you live in one of these states, you can be indifferent as to whether the bonds are issued in your state or not. Many times, you will notice that states with no income tax offer slightly higher yields. This is to offset for the fact that their bonds are not specifically attractive to their own citizens since there is no local tax benefit.
New York City Has a City Income Tax
Municipal bonds issued in the state of New York are exempt from city and state income taxes. Municipal bond interest from bonds issued in the state may be triple tax-exempt from city, state, and federal income taxes.
Utah Reciprocates Taxation
Utah does not tax its own bonds, but also does not tax bonds issued in states that do not tax Utah bonds. In other words, if a state does not collect taxes on Utah’s bonds, Utah does not collect interest on that state’s bonds. This means that residents of Utah can buy bonds from states with no income taxes such as Texas and Washington and avoid paying Utah state income taxes on the interest.
Our capital’s district does not tax in-state or out-of-state municipal bonds. This means Washington D.C. residents can buy bonds from anywhere and not pay state or district income taxes on the interest.
States That Tax In-State Bonds
These states tax in-state bonds in most instances as well as out-of-state bonds:
There are a few exceptions. For the most part, residents of these states should look at bonds from other states with the same regard as bonds issued within their states. You will likely have to pay state income tax either way.
For most other states, the basic rule is that only interest from bonds issued within the state is exempt from that state’s income taxes.
It is not necessary to be obsessed with having your bonds exempt from state income taxes. The bulk of your tax savings are going to result from not having to pay federal income taxes. When it comes to state taxation, a smarter bet would be to diversify your portfolio across many states. It may cost a bit in terms of state income taxes, but your portfolio would not be subject to risks that are isolated geographically. Additionally, having a much bigger pool of bonds to choose from when you look across all states is invariably going to allow you to find a few bonds that will yield enough to offset having to pay state income taxes.
NOTE: It should be noted that interest from U.S. treasury bonds are exempt from state income taxes. When you are comparing a municipal bond that may be taxable in your state with a U.S. treasury bond, you should account for the fact that the U.S. Treasury bond’s interest is exempt from your state’s income taxes.