As Tax Season Arrives, 8 Ways You Can Get Taxed on Municipal Bonds

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It’s tax season and the April tax filing deadline is less than two weeks away. Death and taxes are both supposed to be unavoidable. Most people do eventually come to the realization that death is the inevitable outcome in the game of life. When it comes to investing, some investors do manage to get tax-free income by investing in municipal bonds. Some muni-bond investments just might not be quite as tax-free as some investors hope.

After featuring the 19 mistakes that the IRS does not want you to make, 24/7 Wall St. wanted to remind investors that the world of muni bonds can still create instances in which investors may have to pay taxes.

What is generally not taxed at the federal level by the Internal Revenue Service is basic coupon payments and income. Other aspects of muni-bond investments may get taxed directly, while other aspects of them may inadvertently trigger other federal taxes. There can also end up being taxes at the state level.

It is always important for investors to understand exactly what it is that they own. It is each investor’s responsibility to know whether or not they will get taxed on something they think is tax-free. Relying solely upon a broker to say a muni-bond is tax-free will not get investors out of a tax bill. Sadly, investors also might have to pay taxes even though a tax professional might have thought a muni-bond investment was tax-free.

Here are eight ways that investors can still get stuck with a tax bill on municipal bond investments. Unfortunately, there are likely other ways that investors may find out their tax-free investment wasn’t quite as tax-free as they thought.

1. Capital gains taxes.

The most basic formula for bond investing is that yields and bond prices move inversely. As interest rates fall, the face value of a bond (all things being equal) will rise. If you own a 20-year municipal bond with a 4% coupon, and in just a few years the same municipality can issue debt at a 3% coupon, the value of that bond has likely risen considerably. If that investor sells out at a profit before maturity, then a capital gain was just created that can be taxed at the federal level. It may also be taxed as a capital gain at the state tax level, depending on the state in which the investor lives. One way to avoid getting a capital gains tax on a muni-bond is to “hold to maturity.”

2. State income taxes in muni-bonds.

State and locally issued tax-free municipal bond income is not taxed at the federal level. Most states do not tax that income if the bond is issued in that same state, but they may have a tax on a muni-bond that is issued from another state. This varies greatly from state to state, and one rule of thumb is that the states with higher taxes tend to tax these out-of-state muni-bonds. Investors that reside in a state without a state income tax get to avoid a state-level tax on municipal bonds.

3. Some muni-bonds aren’t even tax-free!

Unfortunately, not every single muni-bond is automatically tax-free on the income portion. A small amount of muni-bonds that have been issued are classified as taxable municipal bonds. Some of these bond issuances by a city, county or other district may be issued to help an underfunded pension system. Others might fall under the Build America Bonds program. These can be taxed at the federal level, even though they might still avoid certain state income taxes. A good rule of thumb is that taxable muni-bonds usually have higher yields than their tax-free counterparts — usually. It is each investor’s responsibility to make sure that the high-yield tax-free coupon that sounded too good to be true might actually taxable after all.