Tax Free Municipal Bonds

How does investing in municipal bonds tax free?

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 local levels.

Interest on issues of US territories is subject to a triple exemption (federal, state, and local).

Investing in your state's municipal bonds

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 municipal bonds

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 Bond Yields.

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.