Residents of the issuing state are generally excluded from federal and state taxes on income earned from municipal bonds. While interest income is tax-free, any capital gains delivered to the investor are taxable.
Why are municipal bonds exempt from federal taxation?
The most compelling economic argument for municipal bond tax exemption is that it encourages state and local governments to invest in infrastructure projects that benefit nonresidents.
What are the tax implications of taxable municipal bonds?
Federal Programs and Taxability Most municipal securities are exempt from federal income taxes, and most jurisdictions exclude in-state bond interest from state income taxes as well.
What bonds are exempt from taxes?
Tax-exempt municipal bonds are divided into two categories based on how the money borrowed is repaid: general obligation bonds and revenue bonds. Bonds, notes, leases, bond funds, mutual funds, trusts, and life insurance are among the tax-exempt investment vehicles.
Are municipal bonds exempt from federal taxes?
Municipal bonds (sometimes referred to as “munis”) are fixed-income investments that offer better after-tax returns than comparable taxable corporate or government issues. Interest paid on municipal bonds is generally excluded from federal taxes and, in some cases, state and local taxes as well.
Which government bonds are exempt from paying taxes?
A government entity issues tax-free bonds to raise revenue for a specific purpose. Municipal bonds, for example, are a type of bond issued by municipalities. They have a fixed rate of interest and rarely default, making them a low-risk investment option.
The most appealing aspect, as the name implies, is the absolute tax exemption on interest under Section 10 of the Income Tax Act of India, 1961. Tax-free bonds often have a ten-year or longer maturity period. The money raised from these bonds is invested in infrastructure and housing initiatives by the government.
When did municipal bonds become free from taxation?
Roads, bridges, airports, schools, hospitals, water treatment facilities, power plants, courthouses, and other public structures are examples of significant, expensive, and long-term capital projects for which state and municipal governments issue bonds. State and municipal governments can, and do, pay for capital investments using current income, but borrowing allows them to spread the expenses across numerous generations. Future users of the project pay a portion of the cost through rising taxes, tolls, fares, and other fees that help pay off the obligations.
To assist smooth out unbalanced financial flows, states and municipalities issue short-term loans or notes (e.g., when tax revenues arrive in April but expenditures occur throughout the year). They also issue debt for private companies (e.g., to build projects with public benefit or for so-called public-private partnerships).
HOW LARGE IS THE MUNI BOND MARKET?
State and local governments had $3.85 trillion in debt at the end of 2019. (figure 1). Approximately 98 percent of this debt was long term, having a maturity of at least 13 months, while only 2% was short term. As in previous years, states issued around 40% of municipal debt while local governments issued 60%.
Municipal debt has more than tripled in nominal terms since the mid-1980s, but the shift as a proportion of GDP has been less significant.
What Are the Main Types of State and Local Government Debt?
General obligation bonds are backed by a company’s “full faith and credit,” which includes the ability to tax. Future revenue streams, such as dedicated sales taxes, tolls, and other user charges generated by the project being financed, may also be used to secure bonds.
Generally, general obligation bonds require voter approval and are subject to debt-to-equity limitations. These rules and limits do not apply to revenue bonds or bonds secured by projected legislative appropriations. In 2018, revenue bonds accounted for 58 percent of state and municipal issuances, general obligation bonds for 36%, and private placements for 6%.
Who Holds State and Local Government Debt?
Households hold the majority of state and municipal bonds, followed by mutual funds (which also represent household investors) (figure 3). Until the Tax Reform Act of 1986 and subsequent lawsuits, banks and life insurance corporations were the most major municipal bond holders.
How Does the Federal Tax Exemption Work and What Are Proposals for Reform?
The federal income tax has exempted interest payments from municipal bonds from taxable income since its introduction in 1913. Interest on bonds issued by the taxpayer’s home state is usually free from state and municipal taxes. In Department of Revenue of Kentucky v. Davis, the US Supreme Court maintained states’ power to tax interest on bonds issued by other jurisdictions.
For a given degree of risk and maturity, state and local governments can borrow more cheaply than other debt issuers, such as companies, thanks to the federal tax exemption. As a result, the federal tax exemption acts as a federal subsidy for state and municipal infrastructure spending. This subsidy comes with a price tag of $28 billion in lost tax income in fiscal year 2020.
The federal tax exemption has been criticized as wasteful since it provides high-income taxpayers with more than the required incentive to buy municipal bonds. A high-grade tax-exempt municipal bond, for example, yielded 3.53 percent in 2018. A comparable taxable corporate bond yielded 3.93 percent. As a result, taxpayers with a federal tax rate of around 10% should be able to choose between the two types of bonds (the yield difference—0.4 percentage points—is roughly 10% of 3.93 percentage points). Anyone in a higher tax bracket earns a windfall, while the borrower receives no further advantage.
Because of this inefficiency, ideas to reduce the federal tax exemption have long circulated, most recently by former Vice President Joe Biden as part of his 2020 campaign tax proposals. However, whether states and localities respond by issuing more or fewer bonds, and whether bondholders respond by changing their portfolios toward taxable bonds or other investments, will determine the revenue benefit from eliminating or reducing the deduction (Poterba and Verdugo 2011). It’s also difficult to keep all key bond characteristics constant, such as risk, maturity date, fixed versus variable interest payments, and liquidity (Congressional Budget Office and Joint Committee on Taxation 2009).
Notably, the bond interest exemption has not been capped in any of President Donald Trump’s previous budget plans.
I’m not sure if my municipal bonds are taxed.
Bond prices normally fall as interest rates rise, and vice versa. Residents of the issuing state are generally excluded from federal and state taxes on income earned from municipal bonds. While interest income is tax-free, any capital gains delivered to the investor are taxable.
Is it possible to have tax-free bonds?
The interest on tax-free bonds is not taxable, according to the Income Tax Act of 1961. This means that, in addition to capital protection and a fixed annual income, you will not have to pay any tax on the income produced from tax-free bonds.
What exactly are municipal bonds, and how do they get taxed?
A municipal bond, often known as a muni, is a type of debt security that is used to finance capital expenditures for a county, municipality, or state. Municipal bonds are usually tax-free at the federal level, but they may be taxed at the state or municipal level, depending on the conditions.
Is interest on municipal bonds taxed by the IRS?
Municipal Bonds (Munis) are debt obligations that bear interest and are issued by a state or local government. Interest on municipal bonds is generally exempt from federal taxes and may also be excluded from state and local taxes in the state where it is issued. The tax-exempt interest from municipal bonds is reported on Form 1099-INT. Form 1099-INT also reports tax-exempt interest from private activity bonds that is taxable under the Alternative Minimum Tax (AMT). Nontaxability only applies to dividend distributions if you own shares in a municipal bond fund (capital gain distributions are always taxable). Municipal bond interest is also reported to New York State for New York residents.
Unless otherwise specified, any material provided in this FAQ was not intended or designed to be used, and cannot be utilized, for the purpose of avoiding tax penalties that may be imposed on any taxpayer, in accordance with Treasury Department Circular 230.