gains tax, ordinary income tax, and even alternative minimum tax. Here’s what you need to know.
Wealthy people who want to stash their money in a place where it can’t do
much harm (i.e., generate taxable income or return less than they expect at
maturity) often choose tax-exempt municipal bonds as a permanent parking place
for their millions. “Munis” have long been a preferred investment of the rich,
many of whom care more about preserving capital and avoiding taxes than growing
their fortunes or even keeping up with inflation. Municipal bonds generate a
steady stream of tax-free income and pay principal back at maturity, which is
exactly what many wealthy clients want their investments to do. It is the
no-surprise feature of municipal bonds that holds such great appeal for these
investors.
In the old days, municipal bond holders didn’t even have to report the
interest. They could buy municipal bonds in bearer form, take their semiannual
interest coupons to the bank, exchange them for cash, and people (read: the IRS)
never knew how much interest they were receiving or even that they owned a
passel of bonds tucked away in a safe-deposit box.
Municipal bonds were often held until maturity, and if the owner died, the
certificates were quietly distributed to heirs. Bearer bonds were negotiable
instruments, convertible into cash by whoever held them. Alas, the anonymity of
municipal bond ownership and the freedom from reporting responsibilities have
undergone gradual erosion over the years. In 1983 the federal government began
requiring that municipal bonds be issued in registered form. In 1984, municipal
bond interest began to be figured into the calculation of “provisional income,”
which determines whether or not Social Security benefits are taxable. In 1986,
the interest on private activity bonds became subject to the alternative minimum
tax (AMT). But although the pure tax-free status of municipal bond interest has
been undermined somewhat, it remains one of the few sources of tax-exempt income
available today and continues to enjoy the full blessing of the IRS. But before
purchasing any munis for your clients, understand how they can affect his tax
situation.
Taxable equivalency yield
The first matter to address when determining whether municipal bonds are
right for a client is to calculate the taxable equivalency yield. This compares
the after-tax yields of munis vs. equivalent taxable securities for the client’s
tax bracket.
To do it by hand, take the current muni yield for the type of bond you’re
interested in, divide it by the inverse of the client’s tax bracket, and compare
it to the equivalent taxable yield available in the marketplace. For example, if
20-year AAA munis are yielding 5% and the client is in the 33% tax bracket, you
would divide .05 by .67 to get 7.46%. This is the yield the client must earn on
an equivalent taxable bond to end up with the same tax-free 5% from the muni.
As this calculation makes clear, municipal bonds are not appropriate for
low-bracket investors. If you substitute the 15% bracket in the example above,
you see that the taxable equivalent yield is just 5.9% (.05/.85 = 5.9%). Due to
the typical spread between tax-free and taxable bonds in the marketplace, you
would likely be able to find this client an equivalent taxable bond yielding
more than 5.9%. But do the same calculation for a 35%-bracket client and you see
that you would need to find an equivalent taxable bond yielding 7.7% to provide
the same after-tax yield.
The following table shows the taxable equivalency yields for the seven tax
brackets.
| Taxable Income* | |||||||
| Single return | $0- $8,350 | $8,351- $33,950 | $33,951- $82,250 | $82,251- $171,550 | $171,551- $372,950 | $372,951 & over | Sample effective marginal rate for |
| Joint return | $0- 16,700 | $16,701- $67,900 | $67,901- $137,050 | $137,051- $208,850 | $208,851- $372,950 | $372,951 & over | certain high- income taxpayers |
| Tax bracket | 10% | 15% | 25% | 28% | 33% | 35% | 36% |
| Tax-exempt yields (%) | Taxable yield equivalents (%) |
||||||
| 1.0 | 1.11 | 1.18 | 1.33 | 1.39 | 1.49 | 1.54 | 1.56 |
| 1.5 | 1.67 | 1.76 | 2.00 | 2.08 | 2.24 | 2.31 | 2.34 |
| 2.0 | 2.22 | 2.35 | 2.67 | 2.78 | 2.99 | 3.08 | 3.13 |
| 2.5 | 2.78 | 2.94 | 3.33 | 3.47 | 3.73 | 3.85 | 3.91 |
| 3.0 | 3.33 | 3.53 | 4.00 | 4.17 | 4.48 | 4.62 | 4.69 |
| 3.5 | 3.89 | 4.12 | 4.67 | 4.86 | 5.22 | 5.38 | 5.47 |
| 4.0 | 4.44 | 4.71 | 5.33 | 5.56 | 5.97 | 6.15 | 6.25 |
| 4.5 | 5.00 | 5.29 | 6.00 | 6.25 | 6.72 | 6.92 | 7.03 |
| 5.0 | 5.56 | 5.88 | 6.67 | 6.94 | 7.46 | 7.69 | 7.81 |
| 5.5 | 6.11 | 6.47 | 7.33 | 7.64 | 8.21 | 8.46 | 8.59 |
| 6.0 | 6.67 | 7.06 | 8.00 | 8.33 | 8.96 | 9.23 | 9.38 |
| 6.5 | 7.22 | 7.65 | 8.67 | 9.03 | 9.70 | 10.00 | 10.16 |
| 7.0 | 7.78 | 8.24 | 9.33 | 9.72 | 10.45 | 10.77 | 10.94 |
| 7.5 | 8.33 | 8.82 | 10.00 | 10.42 | 11.19 | 11.54 | 11.72 |
*
The income brackets to which the tax rates apply are adjusted annually for
inflation. Those listed above are for 2009.
Municipal bond interest is also state-tax-free if the bondholder lives in the
state where the bonds were issued. To incorporate state taxes into the equation,
use this calculator.
Reporting tax-exempt interest
Financial institutions are now required to report tax-exempt interest, and
taxpayers are required to report it on their tax returns. There are two reasons
for this.
- Tax-exempt interest is added to “provisional income.” The
tax-exempt interest reported on Line 8b of Form 1040 is not
added to income for the purpose of calculating income tax, but it is added to a
Social Security recipient’s “provisional income” for the purpose of determining
if Social Security benefits are taxable. See IRS Publication 915 or
send clients to their tax advisors for the exact formula for calculating a
client’s “provisional income.” If it is over $25,000 (single) or $32,000
(joint), 50% of Social Security benefits will be taxable; if it is over $34,000
(single) or $44,000 (joint), 85% of Social Security benefits are taxable. - Some private activity bonds are subject to alternative minimum
tax. The interest from bonds issued after Aug. 7, 1986, for certain
nonessential private activities such as housing, airports, student loans, and
industrial projects is a tax preference item for the alternative minimum tax.
This means that if the holder is subject to the AMT, such otherwise tax-exempt
interest is added to income and taxed at AMT rates (26% or 28%). (The definition
of private activity bonds does not include qualified 501(c)(3) bonds, New York
Liberty bonds, or qualified Gulf Opportunity Zone bonds.) Note that the American
Recovery and Reinvestment Act of 2009 restored the AMT tax-free status of
private activity bonds issued in 2009 and 2010. Private activity bonds issued
after 2003 and refunded in 2009 or 2010 will also be exempt from the AMT.AMT bonds tend to carry higher yields in the marketplace, but not enough to
cover the AMT, so they are only appropriate for clients who do not expect to be
subject to the AMT during the period of bond ownership. Although you’ll want to
avoid AMT bonds for clients who could be subject to the AMT, your other clients
might appreciate the higher yields associated with them.
Taxation upon disposition
The taxation of municipal bonds upon disposition can be quite complicated and
is a matter for clients’ tax advisors to figure out. However, you should know
the basic rules so you can make clients aware that the term “tax-exempt” applies
to the interest only. Portfolio management activities may result in some form of
taxation.
- Capital gains and losses. If a client buys a bond at par,
the difference between the selling (or redemption) proceeds and the client’s
cost basis is a capital gain or loss. So if a client buys a municipal bond for
$5,000 and sells it prior to maturity for $4,500, he will report a capital loss
of $500, either long-term or short-term depending on the holding period. The
loss may be used to offset gains or other income.As with all bonds, the price of a municipal bond trading in the open market
will reflect changes in interest rates, credit quality, and other factors that
impact the relative yield of the bond as perceived by market participants. Of
course, if the bond is held to maturity, the bondholder will receive par value
(assuming the issuer doesn’t default, which is rare in the municipal market).
Some clients may prefer to sit on their bonds while others may appreciate the
yield-enhancing and tax-loss harvesting benefits of active management.Note that special tax rules apply to municipal bonds purchased at a discount
or premium. - Original issue discount. If a bond is originally issued at a
discount to par value, the difference between the issue price and the amount
payable at maturity is considered original issue discount (OID) and is not
taxable as a capital gain. Instead, it is treated as tax-exempt interest. So if
a bond is originally issued at $4,700 and pays $5,000 at maturity, the $300 OID
is not taxable. However, if an OID bond is sold prior to maturity, the owner’s
basis is adjusted to reflect the gradual accretion of the OID and may result in
a gain or loss. - Market discount. If a client buys a municipal bond in the
secondary market for less than par value, it is considered a market discount. If
the bond is redeemed at par value, the difference between the purchase price and
the redemption price is taxable as ordinary income—not capital gains. This rule
was instituted May 1, 1993, and applies to bonds purchased after that date. If
the bond is sold prior to maturity, the accreted market discount is taxable as
ordinary income. Basis is adjusted and the balance is taxable as a capital gain
or loss. - Premium. If a municipal bond is purchased at a premium
(i.e., more than the face amount of the bond), the premium is amortized over the
remaining term of the bond and serves to reduce the holder’s tax
basis.
Investing in tax-exempt bonds
Most tax-exempt municipal bonds are issued in denominations of $5,000.
Information on new municipal bond offerings as well as bonds available in the
secondary market is available through any dealer registered with the Municipal Securities
Rulemaking Board and online at the Bond Market Association’s website, InvestinginBonds.com.
When choosing municipal bonds for clients consider yield, maturity, quality,
liquidity, and call features, as well as state of issue. For automatic
diversification and/or professional management, recommend one of the many
tax-free income products, including actively managed mutual funds, unit
investment trusts, and exchange traded funds.
For more information on municipal bonds
The following links provide useful information about municipal bonds in
general. If you are looking for information about a specific bond, you can
contact one of the Nationally Recognized
Municipal Securities Information Repositories (NRMSIRs) and provide the
CUSIP number. There is usually a fee for this service.
General information on municipal bonds
Markets and rates
- Monthly
Municipal Market Summary - Bloomberg Markets &
Rates - The Bond Buyer (the “bible” of the
industry)
Rating agencies
Articles
IRS publications
- Brochure on tax-exempt
bonds - Tax-exempt private
activity bonds - Guide to Original Issue
Discount (OID) Instruments, IRS Publication 1212
