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The Preferential Tax Treatment of Municipal Bonds

From an investor’s perspective, the primary benefit of municipal bonds is their preferential tax treatment. Below is a summary of the tax benefits associated with this type of bond.

Exempt From Federal Taxes

Interest earned on municipal bonds is exempt from federal taxes. For this reason, the higher an investor’s tax bracket, the more beneficial a municipal bond investment will be. The American Taxpayer Relief Act (ATRA), which went into effect on January 1, 2013, enhanced this benefit by raising the highest capital gains tax rate from 15% to 20%. The ATRA also raised the highest ordinary income tax bracket from 35% to 39.6%. This rate has since been reduced to 37% by the Tax Cuts and Jobs Act (TCJA), which went into effect on January 1, 2018.

Potentially Exempt From State and Local Taxes

Generally, interest earned on municipal bonds issued within an investor’s home state is exempt from state and local taxes. An investor who purchases an out-of-state municipal bond, however, is subject to state and local taxes on the interest earned.

Exempt From the 3.8% Net Investment Income Tax

The net investment income tax (NIIT) is an additional 3.8% tax that may be imposed on the unearned income of individuals, estates, and trusts. Net investment income includes interest, dividends, capital gains, nonqualified annuities, royalties, rents, and income from passive activities. Interest earned on municipal bonds, however, is exempt from the NIIT.

For additional information on the NIIT and when it may apply, see Section 1411 of the Internal Revenue Code.

Not Includable in Adjusted Gross Income

As a taxpayer’s adjusted gross income (AGI) increases, certain tax benefits begin to phase out. Because interest earned on municipal bonds is not includable in a taxpayer’s AGI, some of these tax benefits may be preserved.

Not Negatively Impacted by the $10,000 Cap on State and Local Tax Deductions

Under the TCJA, single taxpayers and married taxpayers filing jointly may deduct up to $10,000 of combined: (1) state and local property taxes and (2) either (i) state and local income taxes or (ii) state and local sales taxes. Many, if not most, investors who are suitable candidates for municipal bonds will be limited by this $10,000 ceiling and, therefore, will no longer benefit from a deduction of state taxes paid on a different type of investment income, such as interest earned on corporate bonds.

Although municipal bonds typically yield lower returns than taxable investments, they can be a great fit for investors in the highest tax brackets. By performing a simple tax-equivalent yield calculation, investors can compare the after-tax return of taxable investments to the tax-free return of municipal bonds. Consider discussing the potential benefits of adding municipal bonds to your investment portfolio with your financial advisor and tax professional.

Bonds may be subject to state and alternative minimum taxes, and capital gains tax may apply if bonds are sold prior to maturity. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. Do not rely on this information when making decisions with tax consequences. Stifel does not provide legal or tax advice and will not be held liable for any actions or suits based upon the information provided above. Consult your legal or tax professional if expert assistance is required.

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