Tax Free Municipal Bonds
How does investing in municipal bonds tax
Municipal bonds investing is often referred
to as tax free investing. Municipal bonds earn the tax
free title because only the level of government issuing the
bond can tax interest on municipal bonds. That means municipal
bonds are not always totally tax free but mostly tax free.
Who can tax municipal bond interests?
The government issuing the municipal
bond can tax interest on it. For example, interest on municipal
bonds may be taxed by the municipal level (state and local
governments) but not by the federal government.
Interest on municipal bonds issues of the
federal government (T-bills, notes, and bonds) is taxed by the
federal government but is exempt from taxation at the state and
Interest on issues of US territories is
subject to a triple exemption (federal, state, and local).
Investing in your state's municipal
Investors who purchase municipal bonds
issued by the state in which they live often receive a special
tax exemption; they may not be required to pay taxes on
interest to the federal or state government.
For example, if you live in Los
Angeles, CA and buy a California municipal bond, its
interest will not be subject to taxation on your federal or
State of California return. However, if you live in Tempe, AZ
and buy California municipal bonds, the interest will be exempt
from taxation by the federal government but will be taxed by
the State of Arizona. (Moral: Buy local!!!)
Things you need to know before investing in
It is not always better for everyone to
invest in tax free investments. This is because, as a result of
tax advantaged status of municipal bonds interest,
municipalities generally pay lower interest rates than do
corporate issuers. Before investing in any tax free
investments, investors should compare the interest AFTER tax of
the tax free investment to a taxable investment. To do that,
investors should be aware of the tax equivalent yield when
assessing the merits of municipal bonds investment. Tax equivalent yield
calculation will compare the yield AFTER tax of the 2
investments, see Municipal
If you are looking for an investment for
a tax deferred investment account such as an IRA or a tax
sheltered annuity, then it is also not beneficial to invest in
municipal bonds because you are already getting the tax
benefits from those accounts.