Not Always Tax-Free: 7 Municipal Bond Tax Traps

Investors often think of municipal bonds, which are sold by local and state governments to sometimes help 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. Although municipal bonds may not be totally tax-free, we generally don't suggest investors hold them in tax-advantaged accounts, like IRAs, because the interest income they pay is generally exempt from federal income taxes.

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.

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 3.50% would drop to roughly 2.6%. The 2017 tax law increased the AMT exemption as well as the phase-out thresholds, meaning fewer filers will be subject to AMT under the new tax laws. The phase-out threshold is $1,218,700 for 2024 for married filing jointly.

Although the phase-out limits are high now and have substantially reduced the number of filers who are subject to AMT, they are set to fall substantially unless Congress extends them or makes them permanent. The implication is that if you own a muni that's subject to AMT, you may not have to pay the AMT tax on it now but that could change in the future.

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.

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 $206,000 ($103,000 for single filers), you will be required to pay an additional amount for Medicare Part B and Medicare prescription drug coverage.

To determine your Medicare premiums, the Social Security Administration generally uses your most recent federal tax return. For example, to determine 2024 monthly adjustment amounts, the Social Security Administration would use your tax return for tax year 2022 that was filed in 2023. You can learn more about Medicare premiums in the Social Security Administration publication "Medicare Premiums: Rules For Higher-Income Beneficiaries."

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.

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.

Some munis are taxable. For example, roughly 10% of recently issued munis were taxable.¹ 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. Additionally, municipal bonds are subject to similar risks as other fixed income investments like credit and interest rate risk.

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