Municipal bonds – often called “munis” for short – can be an attractive investment option.
What exactly are munis? They are debt obligations issued by government entities. In effect, investors are lending money to the issuer in exchange for interest payments over a predetermined length of time. When that time period expires, the bond matures and the investor recovers the full amount of the original investment.
What’s the tax appeal? There are three main attractions.
- The interest income from munis is exempt from federal income tax. Thus, the higher your tax bracket, the more you can benefit from munis. For someone in the 35% tax bracket, a 4% return on a muni is equivalent to a 6% return from a comparable taxable investment.
- The interest income from munis is usually exempt from state income tax if the bonds are issued by your state of residency.
- The interest income from munis generally doesn’t increase your adjusted gross income (AGI). As a result, you might realize other tax benefits that are linked to AGI.
Are there any potential tax drawbacks to munis? Yes. Consider these points.
- If you sell a muni at a profit before it matures, you must report a capital gain on your tax return.
- The interest income from munis may increase the tax on social security benefits paid by retirees.
- Investments in “private activity bonds” – bonds used to finance non-government functions like stadiums – could trigger the alternative minimum tax.
- Special tax rules may affect munis sold at a discount or purchased at a premium.
Finally, you should consider economic factors besides taxes. Be aware that munis carry a risk of default and may be “called” (i.e., redeemed prior to the maturity date). Get all the information you need for a sound investment decision.