Saving on Taxes With Municipal Bonds
Investing in municipal bonds is a well-known strategy for lowering your tax bill, since their interest income is generally
exempt from federal income tax, and in most cases, from state and local taxation, if the investor resides in the state of
issuance. But interest payments from some municipal bonds may be subject to the alternative minimum tax (AMT) or
even ordinary income tax. What’s more, capital gains on municipal bonds are subject to capital gains tax, just like most
other financial securities. Here’s a current summary of the tax treatment of different types of municipal bond investments.
Different Tax Treatment for Different Municipal Bonds
The term “muni” is generally used as a synonym for bonds with federal tax exemption on interest income. Some state and
city governments may offer additional tax preferences to their residents who invest in locally issued municipal bonds.
This creates scenarios for double tax-exempt and triple tax-exempt securities. Here are the three broad categories of
municipal bonds and summaries of their different tax treatments:



Public Purpose Bonds are those issued to support the general financial needs of states, cities, towns and
independent government entities, such as school, water, sewer, road and utility districts. Many municipal bonds
are general obligations of the issuer (and referred to as General Obligation Bonds), while many others are tied to
specified public revenue sources, such as tolls, fees or taxes and are commonly known as Revenue Bonds. Interest
income from public purpose bonds is generally exempt from federal income tax and possibly state and local tax,
too.
Private Activity Bonds are those issued to support projects that may be sponsored by a government entity but are
intended to provide private or commercial benefits. Among these are bonds issued for industrial parks,
independent hospitals and schools, and some airport facilities. Interest income from these bonds is considered a
preference item and must be included in calculations of the AMT. Therefore, investors with AMT exposure will
pay federal AMT on these bonds. Potential AMT exposure is typically noted in bond offering documents and
brokerage listings.
Build America Bonds were issued as part of the American Recovery and Reinvestment Act of 2009. The
program ended on December 31, 2010, but the bonds can still be purchased on secondary markets. Government
entities that issued them were given a direct subsidy by the US Treasury, although it’s important to note that they
are backed by the credit quality of the issuer, and not the federal government. Income on these bonds is taxable at
the federal level but may be exempt from some state taxes.
Bottom Line: Determining the Value of Your Personal Tax/Yield Trade-Off
Because of their income tax benefits, tax-exempt municipal bonds typically carry lower stated yields than taxable bonds
of comparable credit quality. At the end of 2012, for example, the average yield on a 20-year term Baa-rated municipal
bond was approximately 30% less than the yield on comparable duration Baa-rated corporate bonds. That means that the
presumed income tax benefits of the muni could outweigh the opportunity cost of the lower yield for taxpayers in the
33%, 35% and 39.6% marginal tax brackets. The same benchmark muni yield was also 40% higher than comparably
termed US government bonds. Given their tax advantages, the extra yield from munis after taxes could be even greater.*
Taxable vs. Tax-Free Yield
Tax-Free
2.00%
Yield:
3.00%
4.00%
5.00%
6.00%
Marginal
Federal Taxable-Equivalent Yields
Tax Rate
10%
2.22%
3.33%
4.44%
5.56%
6.67%
15%
2.35
3.53
4.71
5.88
7.06
25%
2.67
4.00
5.33
6.67
8.00
28%
2.78
4.17
5.56
6.94
8.33
33%
2.99
4.48
5.97
7.46
8.96
35%
3.08
4.62
6.15
7.69
9.23
39.6
3.31
4.97
6.62
8.28
9.93
Capital Gains
Although municipal bonds bought at par and held to maturity do not incur capital gains, those purchased below face value
or sold at a gain prior to maturity may incur capital gains tax. Currently, the maximum federal tax rate on long-term
capital gains is 20% for individuals with taxable incomes above $400,000 ($450,000 for married couples filing joint tax
returns). Most others will continue to pay the lower 15% rate on long-term capital gains.
In the end, the tax benefits of a particular municipal bond will depend on a number of factors, and these benefits need to
be weighed against the yield and quality of the particular issue. Let us work with you to find the municipal bonds that
provide the best combination for your particular needs.
Footnotes/Disclaimers
*Source: The Federal Reserve’s reported month-end average yields for 20-year term municipal bonds, the 20-year Treasury Constant Maturity
Yield Curve, and Baa-rated corporate bonds with remaining terms of 20 years or more. Yields as of December 31, 2012.
More information on municipal bonds is available on the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access
(EMMA) website: www.emma.msrb.org.
The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the
maturity value. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a
timely basis. Bonds may also be subject to call risk, the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date.
Bonds are also subject to reinvestment risk; the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. The
tax-exempt status of municipal securities may be changed by legislative process, which could affect their value and marketability.
Article by S&P Capital IQ and provided courtesy of Morgan Stanley Financial Advisor.
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