Bonds are available in both taxable and tax-exempt formats and there are tax concepts to consider when a person is investing in bonds. Each type of bond, whether tax-exempt or not, has different tax aspects. Tax-exempt municipal bonds and taxable bonds are discussed, explaining how some of the tax rules work for these investments and their investment yields.
Acquisition of Bonds
When purchasing tax-exempt municipal bonds at face value or par, there are no instant tax consequences. When the bond is acquired between interest payment dates, the buyer pays the seller interest that has accrued since the last payment date. The interest paid in advance to the seller is treated as the cost of the investment and is treated basically as a return of some the initial investment when the interest is paid.
Bond Premium Amortization
When tax-exempt municipal bonds are purchased at a premium, the premium is amortized for the duration of the bond term. The effect of this is to decrease the cost of the investment in the bond on a pro rata basis. Thus, holding the bond to maturity means no loss recognized when the bond is paid off.
Interest Excluded From Taxable Income
Normally, tax-exempt municipal bond interest is not added to income for tax purposes (although, the interest may be taxable under alternative minimum tax rules). Also note, municipal bonds usually pay lower interest rates as compared to similar bonds that are taxable.
When comparing taxable investments to tax-free investments, the amount of interest included in income is not the most important issue. What is important is the after-tax yield. For tax-exempt municipal bonds, the after-tax yield is usually equivalent to the pre-tax yield. On the other hand, a taxable bond’s after-tax yield will be based on the amount of interest remaining after deducting the corresponding amount of income tax expense associated with the interest earned on a taxable bond.
The after tax return of a taxable bond depends on a person’s effective tax bracket. In general, tax-free bonds are more appealing to taxpayers in higher brackets; the benefit of not including interest earned in their taxable income is greater. In contrast for taxpayers in lower brackets, the tax benefit is less substantial. Even though municipal bond interest is not taxable, the amount of tax-exempt interest is reported on the return. Tax-free interest is used to calculate the amount social security benefits that are taxable. Tax-free interest also affects the computation of alternative minimum tax and the earned income credit.
Tax-Free Interest is excluded from 3.8% NIIT
Tax-exempt municipal bonds interest is also exempt from the 3.8% net investment income tax (NIIT). The NIIT is compulsory on the investment income of individuals whose adjusted gross (AGI) is in excess of:
· $250,000 for filing status Married Filing Joint and Qualifying Widower,
· $125,000 for filing status Married Filing Separate, and
· $200,000 filing status Single and Head of Household.
Tax Advantaged Accounts
Purchasing municipal bonds in your regular IRA, SEP, or §401(k) is a no-no. These accounts grow tax free and when withdrawals are made, the amount withdrawn is taxable. Thus, if you desire fixed income obligations in a tax advantaged account consider taxable bonds or similar income securities.
Alternative Minimum Tax Considerations
Interest on municipal bonds is usually not included in income for regular federal income taxes. Interest earned on certain municipal bonds called “private activity bonds” is included in the calculation of alternative minimum tax (AMT). The AMT is a parallel tax system established to make sure that taxpayers pay a minimum amount of taxes. The intention of creating AMT was to prevent people from getting to many tax breaks, for example tax-free interest. The tax breaks are added back into income and cause some people lose tax breaks and pay taxes.
Effects of Tax-Free Interest on Taxability of Social Security
A percentage of social security benefits are taxable when other income besides social security benefits surpasses certain amounts. For this purpose, the amount of taxable social security benefits adds tax-exempt interest into the amount of other income received besides social security benefits to determine the amount of taxable social security benefits. Consequently, if you receive social security benefits, tax-free interest could increase the amount of tax paid on social security benefits.
Effects of Tax-Free Interest on the Calculation of Earned Income Tax Credit
When a taxpayer is otherwise qualified to receive the earned income tax credit, the credit is lost completely when the taxpayer has more than $3,400 (2015) of “disqualified income.” Disqualified Income generally is investment income like dividends, interest -income, and tax-exempt income. Thus, having municipal bond interest in excess of $3,400 causes a taxpayer to lose the credit. However, an individual qualified for the earned income tax credit is in a lower tax bracket and an investment in municipal bonds would yield a lower after tax return as compared to taxable bonds.