Also known as “munis,” municipal bonds are debt obligations issued by state and local governments in addition to other governmental entities to fund the building of highways, hospitals, schools and sewer systems, along with many other projects for the public good.
Munis are attractive to investors in high tax brackets because, in most cases, the interest income is excluded from federal income tax calculations. If investors own municipal bonds issued within their states of residence, interest income may also be excluded from state and local taxes. A limited number of municipal issues are considered an item of tax preference for calculating the federal alternative minimum tax (AMT) imposed on individuals and corporations. Additionally, the bonds may be subject to capital gains taxes if sold or redeemed for profit.
Taxable municipal bonds are an entirely separate market within the municipal sector where interest income is included in federal income tax calculations. However, these issues still offer a state – and often local – tax exemption to investors residing within the state of issuance.
Taxable municipal bonds exist because the federal government will not subsidize the financing of certain activities that do not provide a significant benefit to the public at large. Investor-led housing projects, local sports facilities, refunding of a refunded issue and borrowing to replenish a municipality’s under-funded pension plan are just four types of bond issues that are federally taxable. Yields on taxable munis are typically comparable to those of other taxable issues, such as agencies and corporate bonds.
Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment.