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Posted by Jim McClaflin, EA, NTPI Fellow, CTRC

Municipal Bond Tax Traps to Watch Out For

Municipal Bond Tax Traps to Watch Out For


Local and state governments sell municipal bonds to investors to help fund public projects like repairing a public park or building a new school. While municipal bonds pay tax-free interest (federal and state), it is not always tax-free. Investors might wrongly assume it is tax-free, although it is hardly the case.

Even though municipal interest payments do not have federal income taxes, other taxes apply. Knowing the rules will save you from surprises since municipal bonds are one of the available investments that investors who want to reduce their income tax bills can use. 

This article will explore several taxes you should expect after buying municipal bonds. While such bonds might not be entirely tax-free, having them in tax-advantage accounts such as IRA is a good idea. Whatever interest income they generate, the federal income tax does not apply.

  1. Alternative Minimum Tax (AMT)

The United States operates two income systems: the alternative minimum tax and the ordinary income tax, and it allows several deductions permitted in the ordinary income tax code. Taxpayers must use both tools to estimate their taxes and pay the higher one. 

Municipal bond income, like those used to fund public parks, schools, or airports, will likely have an alternative minimum tax applied. For people who need to pay AMT and have this bond, their interest income will probably be taxed at the AMT rate – 26% or more. 

The implication is that a yield on a municipal bond that pays 3.5% might reduce to 2.6%. There was a phase-out threshold boost from the 2017 tax law, so only a few taxpayers will be subjected to alternative minimum tax for the new tax laws. 

  1. A Boost in Social Security Benefit Taxation

While federal taxes do not apply to municipal bonds, Uncle Sam does not add income from the bond as part of your modified adjusted gross income when they want to determine what part of your social security benefit to tax. 

As a result, if 50% of the benefits from your social security alongside other income, like interest from municipal bonds, is greater than $44,000 for couples filing jointly, and $34,000 for individual filers. You can be taxed on 85% of the benefits from your social security.

With this, consider checking out IRS Pub 915 for people receiving social security benefits. It explores how retirement benefits are taxed. The information can give you an idea of how it will apply to your situation. 

  1. Capital Gains Tax

It is a good idea for people to keep a bond until it matures. However, some situations arise when one might need to sell the bond earlier, with a price offering more than the cost basis – the acquisition price after taking discounts or premiums paid into the account. Such gains will have capital gains tax on them. 

Trying to estimate the cost basis might take a lot of work regarding individual bonds due to the many special reporting rules when adjusting to a bond's acquisition price. It is essential to find the adjusted cost basis for bonds when buying.

  1. State Income tax

For people who buy a bond from their home state, the interest ideally will not be subjected to state income taxes. However, this is only the case if you buy from a state that is not your own. 

Also, some states might have income taxes on interest payments even if you are a resident of that state. 

For people who live in states that issue a lower tax rate or a state with insufficient municipal bonds, it is a good idea to consider other locations. While you might have to pay income tax, the higher yield and diversification edge could compensate for the income tax paid to the state. 



Jim McClaflin, EA, NTPI Fellow, CTRC
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