One of the most attractive benefits of municipal bonds is that interest earned is exempt from federal income tax. In many cases, if you invest in bonds issued by your state or local government, the interest may also be state and local tax-free.
For high-income taxpayers, municipal bond interest is not subject to the 3.8% Net Investment Income Tax (NIIT), which applies to other forms of investment income such as dividends and capital gains.
Unlike corporate bonds, which generate taxable interest, municipal bonds provide tax-free earnings. This can result in a higher after-tax return for investors in higher tax brackets.
Since muni bond interest is tax-free, investors should compare their yield to taxable bonds using the tax-equivalent yield formula: For example, if a municipal bond offers a 3% tax-free yield and your tax bracket is 32%, the equivalent taxable yield would be 4.41% (3% / (1 - 0.32)).
Most municipal bonds are AMT-free, but some private activity bonds may be subject to the Alternative Minimum Tax (AMT). It’s important to check the tax status of specific bonds before investing.
While interest income is tax-exempt, selling a muni bond for a profit may trigger capital gains tax. Long-term gains are taxed at favorable rates, while short-term gains are taxed as ordinary income.
Final Thoughts: Municipal bonds offer a safe, tax-efficient investment option for individuals in higher tax brackets. By providing tax-free income and shielding investors from additional federal and state taxes, they serve as an excellent portfolio diversification tool. If you're considering tax-efficient investing strategies, our financial experts can help you determine if municipal bonds align with your goals.
