Bonds that are generally considered tax-free are municipal bonds, also known as "munis," which are debt securities issued by state and local governments.
Understanding Tax-Exempt Bonds
Municipal bonds are issued by state and local governments and their agencies to finance public projects such as schools, roads, hospitals, and other essential infrastructure. The interest earned on most of these bonds is often exempt from federal income taxes. Furthermore, depending on where you reside and where the bond was issued, the interest may also be exempt from state and local income taxes.
Federal Tax Exemption
A key feature of municipal bonds is that the interest income they generate is typically excluded from gross income for federal tax purposes. This means you generally do not pay federal income tax on the interest you earn from these bonds. This characteristic makes them particularly attractive to investors in higher tax brackets, as the tax savings can significantly boost their effective after-tax return compared to taxable investments.
State and Local Tax Exemptions
The tax benefits of municipal bonds can extend beyond federal taxes:
- Double Tax-Exempt: If you purchase a municipal bond issued by a governmental entity within your own state of residence, the interest income is usually exempt from both federal and state income taxes.
- Triple Tax-Exempt: In some instances, for residents of a city or county that issued the bond within their own state, the interest can be exempt from federal, state, and local income taxes.
Types of Tax-Exempt Municipal Bonds
Municipal bonds come in various forms, each with its own characteristics and revenue sources:
- General Obligation (GO) Bonds: These bonds are backed by the full faith and credit of the issuing governmental entity, meaning they are supported by the issuer's taxing power.
- Revenue Bonds: These bonds are serviced by the revenue generated from the specific project they finance, such as toll roads, water and sewer systems, or airports.
- Exempt Facility Bonds: These are a specific category of private activity bonds where the proceeds are used for certain qualified public or private facilities, often still maintaining a tax-exempt status for federal purposes. Examples can include bonds for solid waste disposal facilities, mass commuting facilities, or sewage facilities.
Important Considerations and Exceptions
While municipal bonds offer significant tax advantages, it's crucial to be aware of certain exceptions and other tax implications:
- Alternative Minimum Tax (AMT): Interest from certain "private activity" municipal bonds may be subject to the Alternative Minimum Tax (AMT), even if they are otherwise federally tax-exempt. Private activity bonds are those where more than 10% of the proceeds benefit a private entity.
- Capital Gains Tax: The tax exemption applies only to the interest earned. If you sell a municipal bond for more than you paid for it, any capital gain realized from that sale is generally taxable, just like capital gains from other investment types.
- Market Discount: If you acquire a municipal bond at a price below its face value in the secondary market (a market discount), the portion of the discount that accrues while you hold the bond may be treated as ordinary income when the bond matures or is sold.
Tax Treatment Comparison of Common Bond Types
To illustrate the differences in tax treatment, consider the following comparison:
| Bond Type | Federal Income Tax | State & Local Income Tax | Notes |
|---|---|---|---|
| Municipal Bonds | Exempt | Exempt (in-state resident) | Interest from some private activity bonds may be subject to AMT. Capital gains are taxable. |
| U.S. Treasury Bonds | Taxable | Exempt | Exempt only from state and local income taxes. |
| Corporate Bonds | Taxable | Taxable | Interest is fully taxable at all levels. |
Who Benefits from Tax-Free Bonds?
Tax-free bonds are particularly advantageous for investors in higher income tax brackets. For these individuals, the tax savings can lead to a higher after-tax yield compared to equivalent taxable bonds. For example, a taxable bond yielding 5% might have a lower after-tax return than a tax-free municipal bond yielding 3.5% for an investor in a high tax bracket, once federal, state, and local taxes are factored in.
