Tax-Saving with Municipal Bonds

Municipal bonds are debt obligations of states, cities, and other public subdivisions. Most, but not all, of them pay interest that is exempt from federal income taxes. This interest is also often exempt from state and local taxes. A small proportion pays taxable interest or interest that is subject to the alternative minimum tax (AMT). Municipal bonds can be purchased through nearly any brokerage company. Investment companies that hold portfolios of municipal funds can also enjoy the tax-exempt income that they provide.

Municipal bonds are a favorite investment of individuals who are looking for ways to lower their tax bills. States, counties, and cities have met this demand by annually issuing tens of billions of dollars in new tax-exempt bonds which are used to finance road construction and maintenance, schools, bridges, hospitals, water systems, and numerous other projects. The tax changes that took effect in 1986 closed many tax loopholes but left municipal bonds as one of the few tax-friendly investments still available to individuals.

Municipal bonds are virtually identical to corporate bonds issued by businesses and government securities issued by the U.S. Treasury. Each bond represents money borrowed by the issuer who pledges to repay the principal amount of the debt (also known as its face value, or par value) to the bondholder on the specified maturity date. In return for the use of the lender’s money, the issuer promises to pay the lender a specific amount of annual interest in equal semi-annual payments. The periodic interest that’s paid is determined by the bond’s principal amount and by the coupon interest rate. For example, a $5,000 face-value bond with an 8% coupon pays $200 in semi-annual interest, or $400 per year, as long as the bond remains outstanding. Interest payments stop on the day that the bond is redeemed and the principal amount returned to the bondholder. The interest payment dates and maturity date are both established at the time the bond is issued.

Municipal bonds are almost always issued in $5,000 denominations, which means that they are bought and sold in $5,000 minimums and multiples of that. You can’t ordinarily invest as little as $1,000 or $2,000 directly in municipal bonds; however, you can acquire indirect ownership by purchasing shares of investment companies that hold them.

Most municipal bonds pay interest that is not included in the bondholder’s taxable income. Tax exemption applies to federal income taxes and, usually, to state and local taxes as well. This is the reason that they remain such an attractive investment. The bondholder is required to list on IRS Form 1040 the amount of tax-exempt income that’s received, but this is for informational purposes only and does not affect his or her tax liability.

The tax exemption of municipal bonds applies only to interest income and not to any capital gains that may be earned from selling the bonds at a higher price than was paid to buy them. Ownership can also result in capital losses if their value declines and they are sold for less than what was paid for them. Realized gains and losses in the value of municipal bonds are treated for tax purposes in the same manner as gains and losses in corporate bonds and common stock.