Not Always Tax-Free: 7 Municipal Bond Tax Traps

Investors often think of municipal bonds, which are sold by local and state governments to fund public projects like building new schools and repairing city sewer systems, as being totally tax-free—but that’s not always the case.

While the interest payments on munis are usually exempt from federal income taxes, other taxes may apply. It’s important to know the rules, because municipal bonds are one of the few investments available to income-oriented investors looking to reduce their income tax bills. Here are seven types of taxes that could apply if you buy muni bonds.

1. De minimis tax. The de minimis tax applies to munis that you acquired at a market discount. The de minimis rule says that for bonds purchased at a discount of more than 0.25% for each full year from the time of purchase to maturity, gains resulting from the discount are taxed as ordinary income rather than capital gains. The ordinary income tax rate is generally greater than the capital gains rate, which could result in a greater bite out of your yield.

For example, take a bond that matures in 10 years with a face value of 100. The de minimis “breakpoint” on this bond is 97.5 (100 – [0.25 × 10 years]). If you bought this bond for less than 97.5, you would be required to pay ordinary income tax on the discount.

De minimis thresholds for a $10,000 face value muni

Source: Schwab Center for Financial Research. The example is hypothetical and provided for illustrative purposes only.

2. Alternative minimum tax. There are two parallel income tax systems in the United States: ordinary income tax and alternative minimum tax (AMT), which disallows a number of deductions that are allowed in the ordinary income tax code. Taxpayers must calculate their tax under each system, then pay whichever is higher—ordinary or AMT.

Income from some municipal bonds—for example, those that fund stadiums, airports or more businesslike enterprises—might be subject to AMT. If you have to pay AMT and hold such a bond, your interest income would generally be taxed at the applicable AMT rate—which could be 26% or more, if you’re in the AMT exemption phase-out range. Effectively, that means the yield on a municipal bond paying 2.00% would drop to 1.48%. The 2017 tax law increased the phase-out thresholds for AMT meaning fewer filers will be subject to AMT under the new tax laws. The phase-out threshold is $1,047,200 for 2021 for married filing jointly.

3. Increase in taxation of Social Security benefits. Although municipal bonds generally aren’t subject to federal taxes, the IRS does include income from such bonds in your modified adjusted gross income (MAGI) when determining how much of your Social Security benefit is taxable. If half of your Social Security benefit plus other income, including tax-exempt municipal bond interest, amounts to more than $44,000 for a joint return ($34,000 for individual), up to 85% of your Social Security benefits may be taxable.

4. Increase in Medicare premiums. If you’re covered by Medicare, the federally tax-exempt interest from municipal bonds may increase the amount you pay for Medicare Part B or Medicare prescription drug coverage. If you’re married and filing jointly and your MAGI is more than $170,000 ($85,000 for single filers), you will be required to pay an additional amount for Medicare Part B and Medicare prescription drug coverage.

Income to determine monthly Medicare premiums may include municipal bond interest

Source: Social Security Administration. Data obtained on 3/31/2021

To determine your Medicare premiums, the Social Security Administration generally uses your most recent federal tax return. For example, to determine 2021 monthly adjustment amounts, the Social Security Administration would use your tax return for tax year 2019. You can learn more about Medicare premiums in the Social Security Administration publication “Medicare Premiums: Rules For Higher-Income Beneficiaries.”

5. Capital gains tax. We generally suggest individual investors hold a bond until maturity. However, if you need to sell earlier and you receive a price greater than your cost basis—your acquisition price after adjusting for any premiums paid or discounts received—the gain will be subject to capital gains tax.

6. State income tax. If you purchase a bond from your home state, generally the interest payments you receive will be exempt from state income taxes. However, interest paid on bonds from outside of your home state typically will be subject to state income tax. Interest payments on some in-state munis may also be subject to state income taxes.

7. Taxable municipal bonds. Some munis are taxable. For example, roughly 30% of the munis issued in 2020 were taxable. Issuance of taxable munis has increased recently as a result of the 2017 tax law changes and low absolute yields. Taxable muni bonds generally yield more than tax-free bonds to make up for the difference.

The bottom line is that municipal bonds offer significant tax advantages and could make sense in the portfolios of many income-focused investors. However, the details matter. If you are highly tax-sensitive and would like to invest in these securities, you will want to make sure you understand how the tax traps mentioned above might affect your portfolio.

If you have questions about your portfolio, you could consult IRS Publication 550, “Investment Income and Expenses,” or check in with your tax advisor.