Tax implications

It’s important to understand how income from debt securities is taxed. The tax treatment depends on who issues the bond.

Corporate bonds

Interest paid by corporate bonds is fully taxable as ordinary income. That means it can be subject to:

• Federal income tax
• State income tax (if the state has one)
• Local income tax (if the city/locality has one)

Federal tax on ordinary income depends on the investor’s marginal tax bracket (up to 37%). Some states and cities impose their own income taxes, while others do not. If this detail matters in a test question, the question will provide the needed information.

US Government bonds

Interest paid by US Government bonds is:

• Subject to federal income tax
• Exempt from state and local income taxes

Because federal tax is usually the largest portion of an investor’s income tax bill, the state/local exemption often produces only modest savings. The size of the savings depends on the investor’s state. For example, high-income earners in Hawaii are subject to a 16% state income tax, while the state of Washington does not have an income tax.

Municipal bonds

Interest paid by municipal bonds is:

• Exempt from federal income tax
• Potentially subject to state and local income taxes

In practice, many investors pay no tax on municipal bond interest. If you buy a municipal bond issued by your state of residence, the interest is typically exempt from:

• Federal tax
• State tax
• Local tax

For example, a California municipal bond generally pays tax-free interest to an investor who is a California resident. However, if a resident of Colorado buys a California municipal bond, the interest may be subject to Colorado state and local taxation. Whether tax applies depends on the investor’s state and city and whether they assess an income tax.

Bottom line: state residents do not pay interest taxes on municipal bonds from their state.

An exception to the residence rule applies to US territory bonds, which are also municipal bonds. The US territories are:

• American Samoa
• Guam
• The Northern Mariana Islands
• Puerto Rico
• The US Virgin Islands

Regardless of residence, these bonds are always tax-free to the investor. For example, residents of Alaska who purchase US Virgin Islands bonds receive all interest fully tax-free.

Municipal bonds tend to fit a specific investor profile. Like other bonds, they can provide income, but their tax benefits affect their yields.

Because municipal bond interest is often tax-exempt, municipal bonds usually offer lower interest rates and yields than comparable taxable bonds. That means the tax benefit needs to be large enough to make up for the lower yield.

In general, an investor must be in a high tax bracket to justify choosing a lower-yielding municipal bond. With a progressive tax system, higher tax brackets apply as reportable income increases. If the investor’s tax bracket is low, the tax benefit may not be worth giving up yield.

Investors in high tax brackets can still earn competitive after-tax returns from municipal bonds. Here’s an example:

A wealthy investor in the 37% tax bracket is considering a corporate bond yielding 7% or a municipal bond yielding 5%.

At first glance, the corporate bond’s 7% yield looks better. But corporate bond interest is fully taxable, while the municipal bond interest is tax-free (assuming the investor is a resident).

To find the corporate bond’s after-tax yield, use the tax-free equivalent yield formula:

$\text{TFEY}=\text{CY x (100\% -TB)}$

$\text{TFEY}=\text{7\% x (100\% -37\%)}$

$\text{TFEY}=\text{7\% x 63\%}$

$\text{TFEY}=\text{4.4\%}$

Your guide:

$\text{TFEY}=\text{tax-free equivalent yield}$

$\text{CY}=\text{corporate yield}$

$\text{TB}=\text{tax bracket}$

After taxes, the corporate bond yields 4.4%, which is below the municipal bond’s 5% tax-free yield. In this situation, the municipal bond is the better choice because the investor’s tax bracket is high.

What if the tax bracket is lower?

An investor at the 25% tax bracket is considering a corporate bond yielding 7% or a municipal bond yielding 5%. What is the tax-free equivalent yield of the corporate bond?

Can you figure it out?

With a 25% tax bracket, the corporate bond’s after-tax yield (5.25%) is higher than the municipal bond’s 5% tax-free yield. This is why municipal bonds are only suitable for those at high tax brackets.

We haven’t learned about them yet, but municipal bonds are also unsuitable for retirement plans. Retirement plans, like individual retirement accounts (IRAs), are tax-sheltered investment accounts. No matter what type of investment is in the account, the investor does not pay taxes at the time they make a return on their investments. Taxes are generally paid when the account owner pulls money out of the account in retirement.

Investors typically avoid municipal bonds in retirement accounts because the account already provides a tax shelter. In other words, it usually doesn’t make sense to buy a low-yielding, tax-free bond inside an account where taxes are already deferred or avoided. Instead, investors often hold higher-yielding taxable bonds (like corporate or US Government bonds) in the retirement account and benefit from the account’s tax treatment.