Are Tax-free Bonds Really Free?

Tax-free bonds are an attractive option for investing but are they really tax-free? There can still be a tax impact even if the bonds are advertised as a “tax-free” investment. Municipal bonds (“munis”) are debt securities issued by state and local governments and are generally federal tax-exempt to their owner. Most municipal bonds will be fully taxable for state purposes. In some cases, a municipal bond may be “double exempt” meaning the interest on these bonds will be tax-exempt at both the federal and state level. While the exempt income will not increase your adjusted gross income, it will be considered when determining the amount of your social security benefits that will be taxed each year.

What does a buyer need to beware of when purchasing a tax-free bond?

When purchasing a tax-free bond at its face amount there are no immediate consequences, however, if you buy a municipal bond between interest payment dates, you will have to pay for the interest accrued since the last payment date. The amount is treated as a capital investment for the buyer and would be deducted from the next interest payment that you receive. Interest income from tax-free bonds is excluded from federal income except, in some instances, it could be subject to the Alternative Minimum Tax (AMT).

Should I include tax-free bonds in my IRA or 401K Portfolio?

As an investment, municipal bonds often have lower interest rates than riskier investments like corporate bonds or stocks, and they may offer stability for your capital with low default rates. For those who have a 401K or a traditional IRA, including municipal bonds to save income taxes does NOT make sense. While the income is federal tax-free when owned in an after-tax investment portfolio or fund (i.e., held outside the qualified retirement plans), it will be subject to ordinary income tax rates when the Required Minimum Distribution is taken from the 401k or IRA. In that case, the tax-free benefit of owning municipal bonds would be lost.

What about net investment tax and tax-free bonds?

Another benefit of tax-free bonds is that their interest is also exempt from the net investment income tax (i.e., the NIIT).  This is a tax that is imposed on the net investment income of individuals whose adjusted gross income exceeds $250,000 for joint filers and $200,000 for other filers.

Please contact Wegner CPAs if you have more questions on tax-free bonds or the rules applying to them.