How are municipal bonds taxed?

Interest from bonds issued by states, cities, counties and their agencies is generally exempt from federal income tax.

If you hold a bond issued in your own state, the interest is usually exempt from that state's income tax as well, which is where the phrase double tax-free comes from. Some cities add a third layer.

Buy a bond from another state and the interest is still federally exempt but usually taxable by your home state, which is why single-state funds exist.

Divide the municipal yield by one minus your marginal tax rate. A 3% muni for someone in the 32% bracket is 3% divided by 0.68, which is about 4.4%.

That is the yield a taxable bond would need to leave you equally well off. If corporate bonds of similar quality yield less than 4.4%, the muni wins.

For someone in the 12% bracket the same bond is equivalent to roughly 3.4%, and almost any corporate or Treasury alternative beats it. Municipal bonds are a higher-bracket instrument, and marketing that ignores the bracket is misleading.

Only the interest is exempt. Selling a municipal bond for more than you paid produces an ordinary taxable capital gain, long-term if held over a year.

Bonds bought at a market discount are treated less favourably still: the discount portion is generally taxed as ordinary income on sale or maturity rather than as a capital gain.

So a strategy of trading munis for price appreciation gets none of the benefit that makes them attractive.

Some municipal bonds finance projects that primarily benefit private entities, such as stadiums or certain airport facilities. These are private activity bonds.

Their interest is exempt from regular federal income tax but is added back for the alternative minimum tax, so a taxpayer subject to AMT may owe tax on income the bond was bought to avoid.

Funds disclose their AMT exposure, and AMT-free municipal funds exist specifically for investors who need to avoid it.

This is the clearest asset location rule in investing. A retirement account already shelters income from tax, so putting a tax-exempt bond inside one buys nothing.

What it does cost is yield. You accepted a lower interest rate in exchange for the exemption, and then placed the bond somewhere the exemption is worthless.

The right holding for a retirement account is a taxable bond paying the higher yield, with the munis, if you want them at all, kept in the taxable account where the exemption works.

Municipal interest is tax-exempt but not invisible. It counts toward the calculation that determines how much of your Social Security benefit is taxable, so it can raise your tax bill indirectly.

It also feeds into the income figure used for Medicare premium surcharges, which step up at defined thresholds.

For a retiree near one of those thresholds, exempt income is not entirely free, and the interaction is worth checking with a tax professional before making a large allocation.

A municipal bond fund passes the federal exemption through to you and reports it on your 1099. A national fund holds bonds from many states, so typically only a small percentage escapes your state tax.

A single-state fund solves that but concentrates credit risk in one issuer's economy.

Individual bonds give control over state, maturity and AMT exposure, at the cost of diversification and the work of buying them.

Interest classification, bond premium and discount rules and 1099 reporting are in IRS Publication 550. Walnut is informational and is not an investment adviser. This guide is educational and not personalized tax or investment advice; anything with a tax consequence is worth confirming with a tax professional.