What Determines Whether Interest On A Bond Is Taxable
The interest on bonds issued by state and local governments is generally tax-exempt at the federal level, unless more than 10% of the proceeds are used for trade or business activities by nongovernmental entities, including leasing a public building to a private entity for business use. And nonprofits with 5013 status, including colleges and hospitals, can issue tax-exempt bonds provided that no more than 5% of the proceeds are used for private business unrelated to the nonprofits charitable purposes. Regardless of whether the bond is taxed at the federal level, states independently determine whether they tax municipal bond interest. A 2008 Supreme Court ruling cleared the way for states and localities to exempt their own municipal bonds interest from their own taxes while taxing interest from other state and localities municipal bonds.
Muni Bond Fundamentals Are The Strongest In Decades
To get high yields, you typically have to take more risk. For example, the only major U.S. fixed income asset class yielding more than muni bonds is high yield, where issuers are rated below investment grade because they have a higher risk of default.
But heres the good news: Muni bonds not only offer high yields now, they also are a higher-quality asset class. Roughly 85% of the market is rated A or higher.
And current fundamentals are in particularly good shape. Boosted from federal fiscal and monetary policy support during the pandemic, municipal revenues have surprised to the upside in the past two years.
One result is that many state and local jurisdictions have been able to bolster their rainy day funds, provide tax relief, pay down debt or make supplemental pension payments.
In 2022, the public finance system continues to be awash in liquidity, benefiting from federal governmentfunded relief, including the Coronavirus Aid, Relief and Economic Security Act and the American Rescue Plan Act , among others.
At the same time, home prices and wages have continued to rise, lifting municipalities revenues from property taxes and wages. Tax receipts are up 18.2% this year, on average, in the 40 states that provided tax data through July.
This exceptionally strong financial position means that most muni bond issuers are unlikely to default on their payments, even if the economy goes into a recession and causes municipal revenues to decline.
Heres How To Get Double Tax Exemption Iowa Bonds
Iowans are stuck investing in individual municipal bonds if they want to take full advantage of the tax breaks available. The bonds from our state that qualify for both federal and state tax breaks are typically referred to as Iowa double tax exempt bonds.
For an investor not used to investing in bonds, finding these can be complicated and intimidating. Heres what a typical screen will look like when you search for Iowa municipal bonds:
But, to make things even more complicated, it is not as simple as just picking any bond on the list and buying it. Iowa has pretty complicated tax laws that limit what types of municipal bonds give investors a state tax break.
If you remember one thing from this post, let it be this:
NOT ALL IOWA MUNICIPAL BONDS ARE TAX FREE !
What does it take for a bond to qualify for double tax exemption? Heres some of the specific criteria from the Iowa tax code:
So, you need to go through each of the bonds available to you and verify that they meet one of the exemptions above to qualify for the Iowa state tax exemption.
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Think Twice Before Buying Tax
Investors favor municipal bonds, or “munis,” for two main reasons. They are exempt from federal taxes, and they are relatively low-risk investments.
While stable, income-producing bonds warrant a position in any well-diversified portfolio, there are inherent drawbacks to owning munis. Individuals interested in purchasing them need to consider several factors before making muni bonds part of their investment strategy.
In Addition To The Risks What Other Factors Should You Consider When Investing In Municipal Bonds
Tax implications. Consider consulting a tax professional to discuss the bond’s tax implications, including the possibility that your bond may be subject to the federal alternative minimum tax or eligible for state income tax benefits.
Broker compensation. Most brokers are compensated through a markup over the cost of the bond to the firm. This markup might be disclosed on your confirmation statement. If a commission is charged, it will be reported on your confirmation statement. You should ask your broker about markups and commissions.
The background of the broker or adviser selling the bond. A securities salesperson must be properly licensed, and, depending on the type of business the firm conducts, his or her firm must be registered with the MSRB and with FINRA, the SEC or a state securities regulator. You can check out an investment adviser on the SEC’s Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov and a broker on FINRAs BrokerCheck website at www.finra.org/brokercheck. To confirm MSRB registration, you can review the MSRBs registered dealers list at .
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Capital Gains On Selling Tax Exempt Bonds
A municipal bond represents a loan to the issuing municipality, in exchange for regular interest payments and the promise of a return of the face amount of the bond upon maturity. Investors in high-income tax brackets can benefit from buying municipal bonds because their interest is typically exempt from federal income taxes. While interest payments on municipal bonds might be free from federal income taxes, capital gains from selling tax-exempt bonds for a profit, are not.
Benefits Of Municipal Bonds
Tax minimization: Many municipal bonds are exempt from federal taxes, and if the investor lives in the same state where the bond is issued, the muni will often be exempt from state and local taxes as well. This especially benefits investors in a higher tax bracket, as the tax exemption enhances the bonds return.
You might see a calculation for a tax-free municipal bonds tax-equivalent yield, or TEY, which helps investors compare a muni bonds return with that of a taxable bond. Here’s how that calculation works:
TEY = tax-free municipal bond yield /
For example, if an investor in the 35% tax bracket buys a tax-free muni bond yielding 4%, the calculation would go 4 / , and the bonds TEY would be 6.15%. An investor would need to find a taxable bond yielding 6.15% to be comparable to this muni bond.
Being thoughtful about where they purchase tax-free muni bonds can save investors money. For example, many investors in higher tax brackets strategically buy tax-exempt munis in their brokerage accounts, which are taxable. They put their other less tax-advantaged fixed-income investments in retirement accounts like traditional IRAs and 401s that are designed to defer taxes.
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Don’t Let The Tax Tail Wag The Municipal Bond Dog
There can be additional state tax benefits from buying in-state municipal bonds, but doing so can increase exposure to state-specific risks. To adjust, Frazier typically invests in funds that buy municipal bond securities issued by multiple states.
Diversification is primary. Tax savings is secondary, he says. Tax is not the only driver.
Jeff Brooks is a wealth strategist with 23 years of industry experience. Prior to joining Capital Group in 2018, he worked at UBS Financial Services and Merrill Lynch/Bank of America. Earlier in his career, Jeff practiced probate, trust and estate law. He earned his law degree from the University of Missouri. He is a member of the Missouri Bar.
Use Munis To Reduce Taxable Events During Equity Downturns
Munis can help temper client emotions, which offers a tangential call it a behavioral tax benefit. Because municipal bond prices have tended to move independently of stocks, a portfolio cushioned with munis will likely be less volatile during periods of market disruption.
When clients see a more tranquil overall portfolio, they may be less tempted to rashly sell stock holdings. In that way, muni bonds historically lower correlation with stocks can help to reduce taxable capital gains generated from emotionally selling during market volatility.
less volatile, especially in corrections, so clients are more likely to stay the course and not sell out of equity positions, Frazier adds.
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What Are Investment Bonds
When you purchase a bond, you’re essentially lending money to a company or government. Companies and governments issue bonds to raise money for business operations, expansions or large infrastructure projects.
Over the bond’s term, you earn interest on the amount of the bond at an agreed-upon rate. This rate is typically fixed for the life of the bond it can change for some bonds. That fixed, agreed-upon interest rate is why bonds are also typically known as “fixed income” investments because you get back a fixed amount. On most bonds maturity date, you receive back the bond’s par or face value.
When a bond is first issued, the price you pay for the bond is usually its par value. For example, you might purchase a bond with a par value of $1,000 at a 4% interest rate .
After a bond is issued, investors can also sell it before its maturity date. At this point, the bond may sell at a “premium” or “discount.” When an existing bond offers a higher coupon rate than the rate currently offered on new bonds, it typically trades above its par value on the secondary market and becomes a premium bond.
When a bond offers a lower coupon rate than the rate currently offered on new bonds, it typically trades below its par value and becomes a discount bond.
Consider Munis Rather Than Cash Even In Smaller Accounts
Darrell Pesek, director of the Ashcroft Pesek Group in Houston, finds a variation of this strategy can also be beneficial. A vast majority of the firms $2 billion in assets under management are held in ExxonMobil employees IRAs. Where municipal bonds come in is when clients receive large taxable distributions in the form of non-qualified pensions and executive compensation benefits at retirement. Sometimes this cash piles up after clients begin taking required minimum distributions at age 70½. Pesek uses municipal bonds as a way to drive higher yields than a savings account would offer, while controlling the tax impact.
He says municipals are solid choices even for clients not in the highest tax brackets. You get a lot of bang for your buck on the muni side, Pesek states.
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Municipal Bonds The Basics For Iowa Investors
Municipal bonds provide income that is not subject to income tax at the federal or the state level. But ONLY IF the municipal bonds are issued in your state.
For residents in high tax states like Iowa, investing in any one of todays large municipal bond ETFs or mutual funds is not giving you all the tax breaks you are eligible for.
Iowans have a few extra hoops to jump through in order to invest in municipal bonds that exempt them from both federal AND state taxes. However, the extra hassle can save you thousands in taxes.
Heres a quick review of how municipal bonds differ from other bonds, and why Iowans may not want to be investing in big municipal bond funds from Vanguard, iShares, or other large fund companies.
High Yields For A High
The Bloomberg Municipal Bond Index declined 12.5% this year through November 7one of the worst-performing years in history. But its yield has risen from 1% to almost 4%.
More importantly, the tax-equivalent yield has risen to 7%the highest level in over a decade.
This means muni bonds are outperforming the 4% yield for Treasuries and 6% yield for the JULI Investment Grade Corporate Index. They are even topping the close to 6.5% annualized return for the S& P 500 Index since 2000.
Muni bonds also look attractive compared to Treasuries when expressed as a yield ratio using same-maturity Treasuries.
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Are Municipal Bonds Always Tax
Municipal bonds can be an attractive investment if youre looking for bonds that generate consistent income with low credit risk. Tax-free municipal bonds may be even better since theyre tax-exempt in nature. But theres one thing to know about investing in muni bonds: tax-exempt status is not always guaranteed. There are certain scenarios in which you may still have to pay taxes on income from municipal bonds. If you hold these bonds in your portfolio or are thinking of investing in them, its important to understand what that could mean from a tax perspective.
A financial advisor can help you sort out your retirement accounts and create a plan for retirement. Find a financial advisor today.
The Alternative Minimum Tax
Although it is relatively uncommon, some muni bonds are federally taxed if the holder is subject to alternative minimum tax . If you are unsure whether a specific muni is subject to AMT, consult the broker before purchase.
For example, a bond that is used for a particular municipal improvement that is not backed by the credit of a state or municipality, but rather that of a corporation , would be subject to AMT.
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Why The Surge Now
One big reason is a provision of the 2017 Tax Cuts and Jobs Act, which prohibited the use of tax-exempt bonds for advanced refunding transactions, a refinancing maneuver we describe below. Previously, when interest rates declined, issuers of tax-exempt municipal bonds could issue a second tax-exempt bond to refinance their debt. Now, entities that want to use advanced refunding must issue taxable bonds.
Heres how it works: Say a city issues a tax-exempt bond at a 4% interest rate. A few years later, interest rates drop, and now investors will accept 1.5% on a tax-exempt bond. Before 2017, the city would have issued a second tax-exempt bond, and essentially redeemed the outstanding portion of the initial bond, similar to a homeowner refinancing a mortgage. In practice, the city takes the proceeds from the second bond, and invests the funds in an escrow account. The interest earned on those funds pays the debt service on the first bond issued, and the citys total borrowing costs fall.
With the 2017 Tax Cuts and Jobs Act, the city can only issue these refinancing bonds if they are taxable. However, current interest rates on taxable muni bonds are so low that the advanced refunding maneuver is still attractive. In the second half of 2019, nearly 80% of taxable bonds were used at least partly for this type of refinancing.
Should I Invest In Municipal Bonds During Rate Hikes
Municipal bonds, or munis, are popular investments for a few reasons. Most notably, as a government bond, they can be the closest thing to a safe asset that the market offers. And, investors typically pay no federal taxes on the income that these bonds generate, creating an effective boost to their otherwise relatively low rate of return. Ordinarily, this can be a very stable section of the market. But during Federal Reserve interest rate hikes, bond payments can rise and prices fall. This can result in higher yields and lower returns overall, although municipal bonds dont always follow this rule. Heres how it works.
A financial advisor can help you create a financial plan for your investment portfolio needs and goals.
How Bond Yields and Returns Work
All bonds, whether government or corporate, are debt instruments that have three essential elements: par value, market price and coupon rate.
The notes par value is the amount someone originally paid for this bond, and the amount that the issuer will repay to the owner of the bond once it matures. Market price is the amount that someone is willing to pay to buy the bond today. Coupon rate is the interest that the issuer pays to whoever owns the bond at any given time.
Together, these three elements inform an investors yield and their return on the investment.
Example: Bond Yields and Returns
For example, consider a bond with the following characteristics:
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Par Value: $1,000
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Coupon Rate: 5% Annually
Bottom Line
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What Is A Savings Bond
A savings bond is a government bond issued by the U.S. treasury. U.S. savings bonds are often considered some of the safest investments purchasable because they are backed by the U.S. government.There are two common types of savings bonds, Series EE and Series I bonds. While they are very similar, there are some distinctions to pay attention to.
Each year, an investor may invest from a minimum of $25 in U.S. electronic Series I and Series EE savings bonds or $50 in Series I paper savings bonds up to a maximum of $10,000 in electronic savings bonds or $5,000 in paper savings bonds. While in the past bonds were sold in paper form, today a majority are sold electronically through the treasurys website.
Savings bonds are purchased at their face value and earn interest. Series EE bonds earn a fixed rate of interest, where Series I earn a rate that is adjusted for inflation twice a year. If a Series EE bond is held for at least a 20-year term, the savings bond will be worth at least twice what it was purchased for . Bonds must be held for at least one year but can be held for up to 30 years depending on the specific terms of the savings bond.
Can You Lose Money On Municipal Bonds
You can lose the money you invest in municipal bonds if the issuer defaults. That risk is vanishingly small, considering that defaults on municipal bonds reached 0.05% of $3.9 trillion of outstanding debt in 2020, a time during which local tax revenues were decimated by the COVID-19 pandemic.
You also could lose money on muni bonds if you are forced to sell the bonds on the secondary market at the wrong time. The price you get will be determined by the total dollar amount of the remaining interest payments due, factoring in the prevailing rates available on new issues.
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