The landscape · Investing and taxes
Municipal bond interest at high rates
Interest from bonds issued by states, cities, and other local governments is free of federal income tax, and often free of state tax in the state that issued them.
Who this exists for. This exists for a person in a high tax bracket who holds bonds or bond funds in a taxable account. Ticks that show it: I hold investments outside retirement accounts; My household income is well above average.
How it works
Interest on most municipal bonds is excluded from federal taxable income by law, and a state generally exempts its own bonds while taxing bonds from other states. The interest is still reported on the return and still counts in the combined income formula for taxing Social Security benefits and in the income used to set Medicare premium surcharges. The payoff depends on the bracket. A taxable bond's yield after tax is the yield times one minus the marginal rate, so a 5 percent taxable yield is worth 3.2 percent after a 36 percent combined federal and state rate, while a 3.5 percent municipal yield keeps all 3.5. Gains from selling a municipal bond are taxable like any other gain, and a bond bought at a discount can produce taxable income under rules the IRS lists.
What it gives
The interest is free of federal tax, and of state tax for in state bonds.
For a high bracket household the after tax yield can beat a higher yielding taxable bond.
Municipal bond funds spread the credit risk across many issuers.
What it costs, or where the catch is
At a low bracket the lower yield simply means less income with no tax to save.
The interest counts toward taxing Social Security benefits and Medicare surcharges.
The tax advantage is wasted inside an IRA or 401(k), where all interest is already sheltered.
A worked example
Milo is in the 35 percent federal bracket and his state taxes at 6 percent, a combined 41 percent. A taxable bond yielding 5.5 percent leaves him 3.245 percent after tax, since 5.5 times 0.59 is 3.245. A municipal bond from his own state yielding 3.6 percent leaves him the full 3.6. On $100,000 that is $3,600 a year against $3,245, a difference of $355. His cousin in the 12 percent bracket keeps $4,840 of the taxable bond's interest, far more than the municipal bond pays.
Where it goes wrong
The common miss is holding municipal bonds inside a retirement account, where the lower yield buys a tax break the account already had.
Who confirms it for you
For your own numbers, a fee only planner. This page explains how the rule works for people in general; it does not know your situation and does not tell you what to do.
The official source
IRS Tax Topic 403, Interest received. Every figure that changes by year comes from the site's rules table, which the watcher checks against the official page on a schedule; where a figure is not yet verified, this page says so instead of printing a number.
Ask about Municipal bond interest at high rates
A model reads this page and answers from it. It will say when the answer is not on the page. Education, not personalized advice.
Nearby doors
- After tax contributions and the mega backdoor Roth
This exists for a worker whose plan allows after tax contributions above the deferral cap and allows them to be moved into a Roth account.
- The employee stock purchase plan discount
This exists for a worker whose employer offers an employee stock purchase plan that sells company shares at a discount through payroll.
- Nonqualified deferred compensation
This exists for higher earners, usually executives and senior staff, whose employer offers a plan to defer salary or bonus beyond what a 401(k) allows.
- The backdoor Roth and the pro rata rule
This exists for a person whose income is above the Roth IRA phase out and who has no pretax money in any traditional IRA.
- I bonds and Treasury bills through TreasuryDirect
This exists for a person holding cash they do not need for a while, who wants to know what the Treasury sells directly to individuals.
- FDIC and NCUA insurance limits and ownership categories
This exists for anyone with money in a bank or credit union, and especially for a person whose balances at one institution are approaching the insured amount.
Education, not advice. Wealthy Habitat explains how rules work and never recommends what to do with your money. The No Advice Disclosure.