A bond is a debt security issued by a company or government to raise money and cover spending needs. A municipal bond, also known as a muni, is debt security used to fund capital expenditures for a county, municipality, or state. Municipal bonds are commonly tax-free at the federal level but can be taxable at state or local income tax levels or under certain circumstances.
A Brief Introduction to Municipal Bonds?
The fact that municipal bonds are normally free from the federal income tax is one of the most significant benefits that municipal bonds provide to investors. In many cases, these debt instruments are exempt from both local and state taxes as well. This is especially true in situations when the bond's investor resides in the same state in which the bond was previously issued.
To put it simply, when investors purchase municipal bonds, they are essentially lending money to the issuer of the bond in return for a certain number of interest payments that are made over a predetermined amount of time. When this term comes to a close, the bond is said to have reached its maturity date, which is defined as the point at which the investor receives their whole investment principle back. Individuals that fall into higher income tax categories are the most likely to purchase municipal bonds due to the fact that they are free from taxation.
Investors should investigate the tax implications of a bond before making an investment, despite the fact that municipal bonds are often presumed to be tax-free. An person will almost never be subject to state taxation if they invest in a bond that is issued by an entity that is located in their home state. On the other hand, if they purchase bonds issued by a different state, his or her home state may tax the interest income that they get from the bonds.
When it comes to municipal bonds, the interest income is often free from taxation; but, the capital gains that are earned from the sale of a bond are subject to taxes at both the federal and state levels. The difference between the selling price of the bond and the price at which it was first purchased is the amount that represents the capital gain or loss that occurs on the sale of a bond over a short or long period of time.
Taxes on municipal bonds and gains on investments?
The fact that bonds acquired at a discount (less than par value) will be subject to taxation upon redemption at the capital gains rate is something that investors need to be aware of when they are purchasing municipal bonds on the secondary market. It is important to keep in mind that this tax does not apply to payments made with coupons; rather, it solely applies to the principal amount of the bond.
The amount of taxation that is applied on the difference between the net present value and the principal payment at maturity is fifteen percent, which is the capital gains rate.1.As can be seen in the following illustration, the discount bond (from above) will be of no value to the purchaser in this scenario.
Without being aware that the gain is subject to capital gains tax, an investor can wind up paying $96.22 for a bond that is only worth $95.62 by the time the transaction is completed. When evaluating a municipal bond that is being offered for sale on the secondary market, the investor must take into consideration not only the yield to maturity but also the price of the bond in order to ascertain whether or not the return will be impacted by the tax repercussions.
The bad news is that while discount bonds are subject to taxation, bonds that are acquired at a premium do not function in the same manner; they are unable to provide capital losses that may be used to offset capital gains. In light of the fact that the Internal Revenue Service handles tax-free instruments differently from their taxable equivalents, this tax regulation is in direct opposition to the tax rule that applies to the majority of investments, including other forms of bonds.
Bonds issued by municipalities and "De Minimis"?
With regard to municipal bonds, the de minimis tax law is among the most perplexing notions that might be encountered. According to this nugget of tax law, if you buy a bond at a discount and the discount is equal to or greater than a quarter-point per year until maturity, then the gain you realize at the redemption of the bond (par value minus purchase price) will be taxed as ordinary income rather than as capital gains. This is because the discount is equal to or greater than a quarter-point per year until maturity. For those who are in the highest tax rate, this may imply the difference between paying 15% and 37% on the gain2.