Municipal Bonds and Tax Planning

Even though the interest from municipal bonds is generally exempt from federal income tax, there are other tax issues you need to keep in mind when considering whether to purchase a muni.

Only interest is tax exempt

A bond's tax-exempt status applies only to the interest paid on the bond; any increase in the bond's value is taxable if and when the bond is sold.

Don't forget the AMT

Earning tax-exempt interest income from certain municipal bonds may require you to determine if you're liable for the alternative minimum tax (AMT). This income, which is excluded when determining your adjusted gross income (AGI), may have to be included when determining your alternative minimum taxable income.

Even if the interest from a private-purpose bond is specifically exempted from regular federal income tax, it still may have to be considered when calculating whether the AMT applies to you. And 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 bond could change your AMT status.

Use your 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 taxable bonds. Tax-free munis are best held in taxable accounts.

Understanding market discount and original issue discount

Taxation of bonds sold at a discount to their face value can be confusing. There are two concepts that apply: market discount and original issue discount (OID). After a bond is issued, it may be resold on the secondary market for a price that's below par (par being the value of the bond at maturity). The difference between that below-par purchase price and the bond's stated redemption price is known as market discount. Accreted market discount is taxed as ordinary income when the bond is redeemed or sold.

However, some bonds are issued at a price that's below their par value. For example, zero-coupon bonds are issued at a discount; the difference between the issue price and the redemption price takes the place of periodic interest payments on the zero. When you buy a bond that was originally issued at a discount, the difference between that issue price and the redemption value is known not as market discount but as original issue discount (OID).

Why is the difference important? Because market discount and OID are treated differently by the tax code. The IRS taxes market discount as ordinary income (in the case of bonds bought after April 30, 1993; for bonds bought prior to that date, market discount is treated and taxed as a capital gain). For muni bonds that have tax-exempt status, OID income also is considered tax-exempt (though as with interest on other tax-exempt bonds, it must be reported). However, accrued OID might still be considered when determining your AMT status.

To make the matter even more complex, a muni bond could have both market discount and OID. For example, a muni that was issued at a below-par price might later be resold at an even lower price. The difference between that market price and the issue price (adjusted for accrued OID) would be subject to taxation as market discount. (Market discount is taxable regardless of whether a bond's interest is tax exempt.)

As you can see, even tax-exempt muni bonds can still raise tax questions that may require help from a tax professional.