What's Taxable, What's Not

Comparing taxable and tax-free yields involves making sure you understand a bond's tax status. The interest on corporate bonds is taxable by local, state, and federal governments. However, interest on bonds issued by state and local governments — generically called municipal bonds, or munis — generally is exempt from federal income tax. If you live in the state in which a specific muni is issued, it may also be tax free at the state or local level.

Unlike munis, the income from Treasury securities, which are issued by the U.S. government, is exempt from state and local taxes but not from federal taxes. The general principle is that federal and state/local governments can impose taxes on their own level, but not at the other level; for example, states can tax securities of other states but not those of the federal government, and vice versa.

As is true of almost anything that's tax-related, munis can get complicated. A bond's tax-exempt status applies only to the interest paid on the bond; capital gains realized from any increases in the bond's value are taxable when the bond is sold.

When are munis taxable?

Specific muni issues may be subject to federal income tax, depending on how the bond issuer will use the proceeds. If a bond finances a project that offers a substantial benefit to private interests, it is taxable at the federal level unless specifically exempted. For example, even though a new football stadium may serve a public purpose locally, it will provide little benefit to federal taxpayers. As a result, a muni bond that finances it is considered a so-called private-purpose bond.

Also known as private activity bonds, taxable munis are those in which 10% or more of the bond's benefit goes to private activities, or 5% of the proceeds (or $5 million if less) are used for loans to parties other than government units. Other public projects whose bonds may be federally taxable include housing, student loans, industrial development, and airports.

Even though such bonds are subject to federal tax, they still can have some advantages. For example, they may be exempt from state or local taxes. And you may find that yields on such taxable municipal bonds are closer to those of corporate bonds than they are to tax-free bonds.

Agencies and GSEs (government-sponsored enterprises) vary in their tax status. Interest paid by Ginnie Mae, Fannie Mae, and Freddie Mac bonds is fully taxable at federal, state, and local levels. The bonds of other GSEs, such as the Federal Farm Credit Banks, Federal Home Loan Banks and the Resolution Funding Corp. (REFCO), are subject to federal tax but exempt from state and local taxes. Before buying an agency bond, verify its tax status.

Don't forget the AMT

To further complicate matters, interest from private-purpose bonds may be specifically exempted from regular federal income tax, but still may be a factor in determining whether the alternative minimum tax (AMT) applies to you. Even if you are not subject to the AMT when you purchase a bond, more people are feeling its impact each year, and the interest from a private-purpose bond could change your status. A tax professional can evaluate a bond's potential impact on your AMT liability.

Pay attention to muni bond funds

Just because you've invested in a municipal bond fund doesn't mean the income you receive is automatically tax free. Some funds invest in both public-purpose and private-purpose munis and must disclose on their yearly 1099 forms how much of the tax-free interest they pay is subject to AMT. If you own a muni bond fund, review this information periodically, especially if you think you might be subject to the AMT. Note: Before investing in a mutual fund, carefully compare its investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Read the prospectus carefully before investing. A bond fund is subject to the same inflation, interest-rate, and credit risks association with its underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund's performance.

Use a tax advantage where it counts

Be careful not to make a mistake that is common among people who invest through a tax-deferred account, such as an IRA. Because those accounts automatically provide a tax advantage, you receive no additional benefit by investing in tax-free bonds within them. By doing so, you may be needlessly forgoing a higher yield from a taxable bond. Tax-free bonds are best held in taxable accounts.