Tax Free Municipal Bonds | How to Analyze and Buy Municipal Bonds

Municipal bonds are issued at a state, city, or county level. They allow you to invest in local projects and return, receive a fixed rate of interest. Much like other bond types, you will receive your original investment back once the bonds mature.

In the vast majority of cases, you will not need to pay any tax on your municipal bond gains. With that said, some municipal bonds are liable for tax, especially if you purchased them from a state that you do not reside in.

In this article, we explain the ins and outs of how municipal bonds work, how you can make money and whether or not you will be required to pay tax on your gains.

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What are Municipal Bonds?

Before delving into the specific tax treatment of municipal bonds, it is important that we first explain how they actually work. First and foremost, municipal bonds operate much like any other bond type available in the market. They will always come with a fixed rate of interest which is known as the coupon rate.

Expressed as a percentage, the coupon rate dictates how much interest you should be paid each year for parting with your money. For example, if the municipal bonds pay a coupon rate of 5% and you invest $3,000, you will be paid $150 per year. These coupon payments will continue until the bonds mature.

The specific maturity date will vary from bond-to-bond, although this is usually for a number of years. So, if the municipal bonds are issued with a maturity of 6 years, this means that you would receive annual interest payments for the duration of the 6-year term, and then get your original investment back.

Much like US Treasury bonds and corporate bonds, municipal bonds can sometimes be bought and sold on a secondary market. This means that the specific yield on the bonds will go up and down, depending on market forces. If a marketplace does exist, this also gives you the chance to offload your municipal bonds before they mature.

Who Issues Tax Free Municipal Bonds?

Municipal bonds are issued locally, for example by states, cities, or even counties. They allow local authorities to raise much need capital to fund a particular project or a shortfall in tax revenues. For example, let’s say that the state of Massachusetts needs to raise $340 million to build a new highway. The state would not have the luxury of turning to the federal government, meaning that it can’t resort to a loan via the federal reserve.

Instead, the state would need to issue municipal bonds. These bonds operate much like a loan, as investors will lend the state the required funds to build the new highway. In return, the state of Massachusetts would be required to pay interest to bondholders, until they mature.

Are Municipal Bonds Tax-Free?

If you’re a seasoned investor, you will know first hand that all investment types are liable for tax. This typically comes in two forms; tax on dividend payments and capital gains. For example, let’s say that you hold corporate bonds with an NYSE-listed company.

If you make $300 per year in coupon payments, you would need to pay the respective dividend tax rate through your federal return. Similarly, if you sold your corporate bonds on the secondary market at a profit of $3,000, you would also need to pay capital gains tax on this via your federal return.

With that being said, municipal bonds are a special case in the investment space, as in the vast majority of cases you will not need to pay any tax on your coupon payments. For example, if you buy municipal bonds from the state, city, or county that you reside in, you will likely be able to enjoy passive income on a tax-free basis.

However, there might be cases when you do need to pay tax on your municipal bonds which we discuss in further detail below.

Capital Gains on Selling Municipal Bonds on the Secondary Market

Capital gains tax is required when you sell an asset, or group of assets, for more than you originally paid. For example, if you purchase a house for $100,000 and then sell it 3 years later for $250,000, then you would need to pay tax on the $150,000 gain.

This is usually the case regardless of where you buy your municipal bonds from.

With that said, you would only make capital gains on your municipal bonds if you were to sell them before maturity. If you didn’t, you wouldn’t make any capital gains as you are merely collecting your coupon payments until they mature.

Let’s look at a quick example of when capital gains tax might be liable on your municipal bonds.

• You purchase municipal bonds from the state of New York at a face value of $500
• You buy 10 bonds in total, taking your investment to $5,000
• The bonds pay a coupon rate of 5% and mature in 10 years
• 3 years since the issue, the state of New York has a surplus of tax revenues, so the risks of the bonds go down
• As such, the bonds now have a face value of $700
• You decide to sell all of your bonds on the secondary market. You got $7,000 (10 bonds x $700) in total, so you made $2,000 in capital gains (as you originally paid $5,000)

Although you made a profit of $2,000 on your municipal bonds, this won’t be tax-free. As such, you would need to include these gains in your upcoming federal tax return, much like you would with other assets like property, shares, or ETFs.

Capital Gains When Buying Municipal Bonds at a Discount

You will also be liable to pay tax if you buy municipal bonds on the secondary market at a discount. This is where things begin to get confusing, as you will need to pay tax on the difference between the face value and net present value of the bonds.

• Face Value: The face value of the bonds refers to the original value of each bond when they were issued. For example, let’s say that $30 million worth of municipal bonds were issued at a coupon rate of 4%, and each bond can be purchased in denominations of $500. This means that the face value of the bond is $500.
• Net Present Value: The net present value of municipal bonds takes into account the actual market value of each bond. For example, let’s say that you purchased the same bonds on the secondary market at a discount, which means you are making more than the 4% coupon rate. To keep things simple, we’ll say that this takes the net present value of the bonds to $550, as you need to factor in the discounted price that you paid.

As per the above example, the net present value of the bonds is $50 higher ($550) than the face value ($500). This means that you would need to pay capital gains tax on the $50. Although you are required to pay capital gains on municipal bonds purchased at a discount, you cannot offset the tax paid when purchasing bonds at a premium.

Buying Municipal Bonds From Another State

In order to benefit from the tax-free advantages that municipal bonds offer, you will likely need to be residing in the state that issued them. For example, let’s say that you are a resident of Colorado and you buy municipal bonds issued by the city of Denver. As you are a Colorado resident, you can invest in the municipal bonds without paying tax on any of the income generated.

However, if you were a resident of Texas and sought to buy the same municipal bonds issued by Denver, you would all-but-certainly need to pay tax. This would be levied at a state level, meaning the tax would go to Texas, even though the bonds were purchased in the state of Colorado.

The tax would be based on both your coupon payments and any subsequent capital gains should you decide to offload the bonds before maturity. For example:

1. You purchase $5,000 worth of municipal bonds from an out-of-state issuer
2. At the end of year one, you make $300 in coupon payments
3. This $300 would need to be reported as dividend income in your local state tax return
4. If you then sold the bonds in year two at $6,000, you would need to pay capital gains tax on the $1,000 profit.
5. This would be levied at a federal level.

Should I Buy Out-of-State Municipal Bonds?

Although you will likely need to pay tax on your coupon payments when buying municipal bonds from an out-of-state issuer, this shouldn’t put you off. This is because out-of-state issuers might be offering more attractive yields than you can get on home soil. If this is the case, the increased yield might make you more money, even when the income is liable for state tax.

• For example, let’s say that you are able to buy tax-free municipal bonds from your local state. The bonds pay a coupon rate of 6%, meaning that you will earn $600 per year for every $10,000 invested. The coupon payments are tax-free, so you get to keep the full $600.
• You also buy municipal bonds from an out-of-state issuer. The bonds pay 8% in coupon payments, so you’ll get $800 per $10,000 invested. However, you also need to pay a tax of 15% on the income. This means that your $800 annual payments are reduced by $120, taking your total income to $680.
• With that said, although you paid 15% tax on your coupon payments, you still made more than the income derived from your 6% tax-free municipal bonds.

As is the case with all investment types, you will need to weigh up the risks and rewards of each municipal bond. Crucially, paying tax on an out-of-state investment might still work out better for you if the investment offers a more attractive yield.

How to Buy Tax-Free Municipal Bonds

If you’ve read our guide up to this point, then you’ll know that you will need to meet a number of requirements to avoid paying tax on your municipal bonds.

To recap, this includes:

• You must not sell the municipal bonds on the secondary market at a profit
• You must not buy the municipal bonds on the secondary market at a discount
• You must not buy the bonds from an out-of-state issuer (certain exemptions apply)

This means that you will need to purchase the bonds directly from the issuer (primary market) in your state, or from a broker at face value (secondary market). In doing so, and on the proviso that you don’t sell the bonds before maturity, you should be able to avoid federal and state taxes on your municipal bond investments.

Option 1: Tax-Free Municipal Bonds via the Primary Market

If you buy municipal bonds on the primary market, this means that you will be purchasing them at the time of the issue. This is like purchasing shares at the time of an IPO (Initial Public Offering). By using the primary market, you will purchase the bonds on the same conditions as other investors. For example, you’ll get the same coupon rate, face value, and maturity.

With that being said, most municipal bonds will be issued at minimum lot sizes when they hit the primary market. For example, although each bond might come with a face value of $1,000, the issuer might ask for a minimum purchase of $100,000. This makes sense from the perspective of the issuer, as it ensures that bonds are sold quickly and in a cost-efficient manner.

The good news is that most municipal bond issuers will partner with at least one retail bank at the time of the issue. This allows everyday investors to purchase tax-free municipal bonds at much smaller quantities. The bank in question will meet the minimum lot size (say $100,000) and then sell them on a per-bond basis (say $1,000). In return, the bank knows that people are likely to open an account for the privilege of being able to invest in the tax-free municipal bonds.

In much rarer cases, the municipal bonds might be issued directly to the public. This will only be the case if the issuance is for a smaller amount. For example, a local county might issue bonds to help pay for a new highway toll. If the costs do not require the backing of institutional money, then a local issuance might be sufficient. Ultimately, you’ll need to check with your local state, city, or county on any upcoming municipal bond issuances.

Option 2: Tax-Free Municipal Bonds via the Secondary Market

The second option available to you is to purchase the tax-free municipal bonds from the secondary market. In Layman’s Terms, this means that you will be buying the bonds from an online broker. It is important to note that you will need to verify with the broker in question whether or not the bonds will be liable for tax. This will centre on the face value of the bonds and whether they were issued by a state that you reside in.

Step 1: Find an Online Broker That Sells Tax-Free Municipal Bonds

Your first port of call will be to locate an online broker that sells the municipal bonds that you wish to purchase. You will likely need to do some digging, as brokers will only hold a select number of bonds. Even if the broker does sell the bonds you wish to buy, you need to ensure that you look at other metrics. This should include fees, regulation, payment methods, customer support, and more.

Step 2: Open an Account and Verify Your Identity

Once you have found a suitable online broker, you will be required to open an account. The process rarely takes more than 5-10 minutes, and you’ll need to enter the following information:

• First and Last Name
• Home Address
• Date of Birth
• Social Security Number
• Contact Details
• Name and Address of Employer
• Annual Income

All online brokers are required to verify the identity of their customers, so you will now be asked to upload a copy of your passport or driver’s license. You might also need to provide a proof of address, such as a utility bill or bank statement.

Step 3: Deposit Funds

Before you can invest in your chosen tax-free municipal bonds, you will need to fund your newly created brokerage account. The specific payment methods available will vary from broker-to-broker, although this usually includes an ACH or wire transfer. Some brokers also allow you to use a debit/credit card or e-wallet.

Step 4: Buy Municipal Bonds

Once your account is funded, you can then purchase your chosen bonds. Municipal bonds come in varying denominations, which you will need to meet. Some brokers will also stipulate a minimum investment amount. For example, although the bonds might be priced at $500 each, you might need to purchase at least 10. Once you’ve bought the bonds, you will then be entitled to annual/bi-annual coupon payments, until they mature.

Step 5: Hold Bonds Until Maturity

If you don’t want to pay capital gains on your tax-free municipal bonds, you’ll need to hold on to them until maturity. As such, you will continue to receive your coupon payments for the duration of the term. Once the bonds do mature, you will receive your original investment back in full. You can then withdraw the funds out of the broker and back into your US checking account.

Conclusion

By reading our guide all of the way through, you should now know the ins and outs of what tax-free municipal bonds are, and how you can make an investment today. Municipal bonds are not always tax-free, so you need to check this with the respective broker or bank before you part with your money.

This is likely to be the case if you buy the bonds at a discount, sell them before maturity at a profit, or the bonds were obtained from an out-of-state issuer. As we have discussed in this guide, it’s sometimes more beneficial to opt for bonds that are liable for tax if the risks and rewards are attractive, so do bear this in mind!

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Glossary of Bonds Terms

Bond

A bond is when companies or goverments need to generate funds and when you invest you will receive you lump sump back with interest at the end of your agreement.

Treasury Bond

Bonds issued by the United States Department of the Treasury to finance government spending.

Treasury Note

A Treasury Note are bonds issued by the United States Department of the Treasury and last up to 10 years.

Treasury Security

Treasury securities are the bonds issued to investors by the U.S. government

Municipal Bonds

A Municipal Bond is usually issued by local Governments to finance public projects such as roads, schools, and airports. You will recieve you lump sum and interest back at the end of the term.

Corporate Bonds

A Corporate Bond is issued by businesses to raise funds for expansions or projects. You will recieve you lump sum and interest back at the end of the term.

Premium Bonds

A Bond that has no interest rate but your investments are entered into prize draws to win £25 to £1mil.

Savings Bond

Usually offered by Banks and Building Societies, Saving Bonds will last for a fixed term and earn interest. You are not able to access the money during the fixed term.

Fixed Rate Bonds

A Fixed Bond will start and end with same Interest Rate.

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