The Basics of Tax-free Municipal Bonds

State and local governments and their agencies issue bonds in exchange for the use of the capital of individuals and corporations. The bonds obligate the state and local governments to make interest payments and to repay, at some stated time, the principal of the amount borrowed. Municipal bonds can be issued by cities, counties, redevelopment agencies, school districts, publicly owned airports, as well as other governmental entities.

Bonds are General Obligation Bonds (GO’s) if they are to be paid from the general revenue and assets of the issuers. The repayment of GO’s is generally supported by the issuer’s taxing power; the issuer pledges its “full faith and credit.” Bonds are Revenue Bonds if their repayment is restricted to certain types of revenue received by the issuer. Examples are repayment from bridge tolls or user fees at an airport.

If the bonds qualify as “tax-exempt,” the interest income received by the individuals and corporations that hold the bonds is excluded from federal income taxation and usually from the income tax of the state in which they are issued. A bond that is free of federal, state and local taxes is called a “triple-tax free.” Usually, since the bonds enjoy this tax preference, they pay a lower interest rate than taxable debt instruments with a similar level of risk. They are most valuable to taxpayers with relatively high marginal income tax rates. However, in the current economic picture, the yield on tax-free municipal bonds is high relative to the yield on most taxable investments, so you should seriously take a look at tax-free bonds as an investment alternative – even if you pay very little income tax.

Not all municipal bonds are tax-free, such as when they finance private activity. Also, bonds issued for some purposes are subject to the alternative minimum tax.

The tax policy behind the interest exemption was to encourage public capital facilities. Bond proceeds can be used for building schools, highways, sewage systems, and a variety of other projects. The tax exemption is limited to bonds that satisfy broadly-defined “public” purposes. Generally, bonds are considered to have a public purpose if they meet one of two tests: 1) no more than 10% of the proceeds is used directly or indirectly in a trade or business, or 2) no more than 10% of the proceeds are secured directly or indirectly by property used in a trade or business. Bonds that can’t pass the test are taxable and are referred to as private activity bonds.

Taxes reduce the net income produced by bonds so you cannot compare a municipal bond yield directly to a corporate bond yield. When evaluating tax-free municipal bond investments, you must first determine the “equivalent taxable yield” of the bond. This is done by subtracting your effective tax rate from 100% and dividing the tax-free yield by the result.

Here is an example: If you are a Pennsylvania resident in the 25% federal and 3.07% state tax brackets, your combined tax rate is 28.07%. A 3% yield on a PA municipal bond is equal to earning 4.17% on a taxable investment (3% divided by (1 – 28.07%)). A PA municipal bond paying 4% will pay the same (after tax) as a taxable bond or CD paying 5.56% (4% divided by (1-28.07%)).
If you are looking at a bond from another state (e.g., you live in Pennsylvania, but the bond is issued by a New Jersey municipality), you would only take into consideration the federal tax bracket when calculating the taxable equivalent yield.

If you aren’t comfortable with the math, you can go to the Securities Industry and Financial Markets Association (SIFRA) website called, click on calculators, and let the program do the math.

While it is true that interest on the obligations of state or local governments is exempt from federal income taxes under IRC Section 103(a), there can be some other tax consequences you should be aware of.

• Tax-exempt interest from municipal bonds is included in the calculation of the taxable portion of Social Security and Railroad Retirement benefits. In some cases, each $1.00 in tax-free bond interest can result in an additional 85 cents of taxable income, because the additional interest puts you over the limit and 85% of your social security becomes taxable.

• Tax-exempt interest from “private activity bonds” is a tax-preference for purposes of computing the Alternative Minimum Tax (AMT). If you are subject to AMT, then the interest from municipal bonds could be taxed at a rate of 26% or 28%.

• The income tax exemption is only for the interest. If you sell a municipal bond and recognize a gain, that gain is subject to tax just like the gain on the sale of any other security.

• If you buy tax free bonds with money you have borrowed on “margin”, the interest paid on the loan is not deductible as investment interest.

Some municipal bonds are insured, which means that a third-party insurer has assumed the risk of the issuer’s default. The bond issuer must pay a premium for this insurance, which has the practical effect of reducing the investor’s yield. The value of the insurance depends on the financial strength of the insurance company.