Municipal bonds – How are they taxed

Bonds are a type of debt obligation issued by corporations or government agencies. In simple words, it is a loan that an entity needs to raise money for new projects, sustain existing operations, or pay off any debts. So, if an organization issues a bond to an investor, they are borrowing money from them which is repaid over time along with interest. Among all kinds of bonds, municipal bonds are quite popular among investors as they are typically tax-exempt. Also known as “munis,” these are offered to the people by government municipalities including states, cities, and public utilities. The funds acquired with the help of munis are employed for the development of public infrastructure. There are two kinds of municipal bonds — general obligation (GO) and revenue bonds. GO bonds are relatively safer because they use taxes, in most cases property taxes, to repay the investors. Revenue bonds depend on the performance of the project, which is, the amount of revenue it generates. Since it relies on fickle economic factors, investing in revenue bonds is relatively more risky. Investors who belong to the high tax bracket or investors who are seeking an alternative to money market funds for earning better returns should consider municipal bonds. As compared to other bonds, the yields that municipal bonds provide are lower, but the tax benefits rendered by these types of bonds make up for this shortcoming. Individuals investing in municipal bonds are offered interest that is exempt from federal income taxes. The income made via these bonds might also be exempt from local and state taxes if the investor resides in the locality or state that issues the bond. For instance, a bond issued in Chicago would be triple-tax-free (exempt from local, state, and federal taxes) for investors living and paying taxes in Chicago. Because of this, municipal bonds are commonly known as tax-free investments. But if one is investing in a bond issued by another locality or state, then they will need to pay state taxes on the interest they earn. Likewise, capital gains received by selling a bond will be subject to state and federal taxes. In rare cases, municipal bonds that are issued to be tax-exempt may become taxable if the Internal Revenue System believes the funds are used for activities that don’t adhere to the regulations about tax-free status. This may leave a lot of investors disappointed. Similarly, there are some munis that are taxed federally if the holder is liable to AMT (alternative minimum tax). Consulting a broker is wise in case one is uncertain if a particular municipal bond is subjected to AMT. Usually, municipal bonds backed by a corporation, instead of a municipality or state, would be subjected to AMT. Top municipal bonds to check out

  • Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares
  • Nuveen High Yield Municipal Bond Fund
  • American High-Income Municipal Bond Fund
  • Oppenheimer Rochester® High Yield Municipal Fund Class A
  • T. Rowe Price Maryland Tax-Free Bond Fund

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