Tax implications

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

Corporate bonds

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

• Federal income tax
• State income tax (if your state has one)
• Local income tax (if your city 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 a test question depends on a specific state or local tax, that information will be provided.

US Government bonds

Interest paid by US Government bonds is:

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

Because federal income tax is usually the largest portion of an investor’s 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 investor may owe state and/or local tax in Colorado. 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 exists with US territory bonds, which are also considered 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 that purchase US Virgin Islands bonds receive all interest fully tax-free.

Municipal bonds are suitable for a specific type of investor. Like other bonds, they’re often purchased for income. The key difference is that their tax benefits usually come with lower interest rates and yields.

To justify buying a lower-yield municipal bond, an investor generally needs to be in a high tax bracket. With a progressive tax system, higher tax brackets apply as reportable income increases. If the tax benefit isn’t valuable enough, a low-yield municipal bond may not make sense.

Investors in high tax brackets can still earn reasonable after-tax returns from municipal bonds. Consider this 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 looks better. But the corporate bond is fully taxable, while the municipal bond is tax-free (assuming the investor is a resident). To compare them, calculate the corporate bond’s after-tax yield using 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 - but only because the investor’s tax bracket is high.

Now compare what happens at a lower tax bracket:

An investor in 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 in high tax brackets.

We haven’t covered them yet, but municipal bonds are also generally unsuitable for retirement plans. Retirement plans, like individual retirement accounts (IRAs), are tax-sheltered investment accounts. No matter what investment is held in the account, the investor typically doesn’t pay taxes when the investment earns income or gains value. Taxes are generally paid when the account owner withdraws money in retirement.

Because the account already provides a tax shelter, municipal bonds often don’t add much value there. Instead of buying a low-yield, tax-free municipal bond inside a tax-sheltered account, an investor could buy a higher-yield corporate or US Government bond and still avoid current taxation within the retirement account.