The tax benefits of municipal bonds
Investors who are interested in lower-yielding investments that carry lower risks should consider municipal bonds over other fixed-income investments due to the tax benefits. Municipal bonds provide investors with state and federal tax exemption in many cases. Moreover, the amount of interest income that you can earn from these products is attractive relative to other types of investments like treasury securities. This article will provide an overview of municipal bonds, and focus on some of the factors investors should consider.
What are municipal Bonds?
Municipal bonds are bonds issued by a state, county, or municipal to help raise money for funding needs. Many investors choose to invest in these products because of their low level of risk and because investors sometimes do not need to pay federal or state income taxes on these investment products.
There are many factors to consider when deciding what type of municipal bond to purchase:
- State taxes: Your state tax rate can help you determine if it is worthwhile to invest in bonds in your state or outside your state.
- Investment objectives: Municipal bonds are typically lower risk and lower return investments, which are more suitable for investors interested in wealth preservation
- Capital Gains: Municipal bonds could be a good option if you are in a higher income tax bracket, as you are not taxed on the interest income.
Investing in municipal bonds can be a greater way to diversify your investment portfolio, preserve your wealth, and potentially avoid paying federal and state taxes.
The first important benefit of purchasing municipal bonds is that the interest income is exempt from federal taxes. However, you will still need to report these investments when you file your taxes. This is a very important benefit for investors, as interest income from treasury securities is still subject to federal taxes. If you are deciding whether to invest in treasury securities or municipal securities, it is important that you compare the yield of a municipal bond to the after-tax yield of treasury securities. In some cases, a lower-yielding municipal bond could be a better investment because of the tax benefits.
It is important to differentiate between interest income and capital gains when accessing the benefits of investing in municipal bonds. While the interest income is exempt from federal taxes, and also state taxes if you purchase it from your state of residence, you still have to pay capital gains taxes. While most investors who invest in these products are solely focused on the interest income from these products, investors can still unknowingly realize capital gains if they purchase municipal bonds at a discount or invest in certain municipal bond funds.
Another benefit of investing in municipal bonds is that the investor is exempt from state income taxes if the bond issuer is from their state of residence. In general, it is better for investors to first consider investing in municipal bonds issued in their state of residence. However, they can also consider higher-yielding municipal bonds in other states, as the yield may still be higher after paying taxes. Your decision to purchase an in-state or out-of-state municipal bond depends on the yields in these states, and the current state income tax rate in your state.
In-state tax benefits: You do not need to worry about paying income taxes if you invest in bonds in your state. Naturally, investors who live in a state where they pay a notably high state income tax should first begin looking for investments in their home state. However, investors from states where there is no state income tax are free to search for municipal bonds in outside states without having to worry about the consequences.
Example: An investor from Texas does not have to pay any state income taxes. Therefore, this investor is completely free to search for higher-yielding municipal bonds in other states and does not have to worry about state or federal taxes for products from any state.
High-Income Tax States: Investors who are from states with high state income taxes, like California or New York for example, will need to invest in state municipal bonds with substantially higher yields to offset the state income tax they would have to pay. For residents of these states, it makes much more sense to invest in municipal bonds from these states, especially if the yield is similar.
Example: Investors from states like California or New York who are in higher state tax brackets would also most likely benefit more from purchasing in-state municipal bonds. For example, a single person in California who earns more than $66,296/year will have to pay a 9.3% state income tax. Any California resident in this tax bracket who purchased a municipal bond with a 3% yield in California would earn less on a municipal bond from another state that had a 3.2% yield.
Choices: There are plenty of products available in all states, but California, New York, and Texas account for around 40% of all municipal indexes. Moreover, there are also municipal bond funds that invest in a diverse pool of municipal bond products from different states.
Example: Investors can purchase municipal bond funds through their brokerage account, which can be especially attractive as the yield increases significantly when the share price of these bonds declines. However, investors should be prepared to pay capital gains taxes if they trade in and out of these funds.
Different Ratings for Bonds
Municipal bonds all have different ratings, which you can check before initiating a position in these investments:
- AAA: Best possible rating
- AA: High-quality rating
- A: Upper medium grade
- BBB: Medium grade
Yields for lower grade products will generally be higher, but these products carry more risks. The average yield for a municipal bond in 2022 was around 2.5%, which is slightly lower than the average treasury yield on a pre-tax basis.
It may make sense for you to diversify this investment in different states, especially if you are worried about economic conditions in your state. However, municipal bonds have historically been much more stable relative to other types of corporate bonds, as the default rate for municipal bonds has been around 0.1% since the 1970s. The main benefit of diversifying is to maximize your post-tax return by deciding whether it financially makes sense for you to invest outside of your home state or not.
Investing in the Secondary Market
If you invest in municipal bonds on the secondary market and purchase them at a discount, you may have to pay capital gains taxes. This is important to consider, as investors may assume they don’t have to pay taxes because the interest income is exempt from federal taxes. Moreover, if you pay a premium and the price declines you can’t count this as a capital loss. Therefore, you can’t plan for losses like this for tax loss harvesting purposes. However, the losses from some of your equity investments can be used to offset capital gains from municipal bonds.
Investing in municipal bonds can be a great way to avoid capital gains taxes and gain relative risk-free income, as the default rate for municipal bonds is extremely low. Therefore, investors can primarily focus on the after-tax yield of these products, depending on which state they are from, and make the best decision based on their taxes. These products are much less risky than traditional equity investments and may offer a similar or higher yield than traditional treasury securities, because of the comparative tax benefits of municipal bonds.
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This post was written by Sean Allaband