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Tax Free Interest Income In Municipal Bonds

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Tax Free Interest Income in Municipal Bonds

 

Municipal bonds are issued by cities, counties, and agencies, including universities, water and sewer districts, and municipally-backed private activities such as stadiums and aquariums. The 2003 tax act made municipals less attractive relative to taxable bonds or corporate stock. But municipals are still the cornerstone of most high-income investors’ bond portfolios:

  • Municipal bond interest is free from federal income tax.
  • Most municipals are free from state tax in their home state.
  • Puerto Rico municipal bonds and bond funds are free from state tax in any state. These may be appropriate if your home state taxes in-state bonds.
  • Municipal bond interest income isn’t included in AGI. This makes them even more valuable if your high AGI phases out exemptions, deductions, and credits.
  • Interest income from “private activity” bonds sold after August 1, 1987 to finance stadiums and similar projects is subject to Alternative Minimum Tax.
  • Municipal bond interest is included in “provisional income” for purposes of calculating tax on Social Security benefits.

Since municipal bond interest is tax-free, issuers can pay lower rates. The key rate is “taxable equivalent yield” - the pre-tax rate you’d have to earn with a taxable bond to equal the municipal’s tax-free yield. The table below illustrates taxable equivalent yields for selected interest rates. However, state and local taxes also affect your taxable equivalent yield:

 

 

 

 

 

 

 

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