Liberate Ambiguity of Interest Exempt from Federal Taxes

Is it safe to assume that all municipal obligations are exempt from federal tax? In short, no. Before we dive into the nuances, let’s discuss the fundamentals of municipal securities. A debt security issued by a state municipality, county and other subdivisions of a state, is known as a municipal bond. The income generated from this type of investment is generally exempt from federal income taxes. This includes the interest you receive from the security, and if you are a corporation that purchased the security on the secondary market, any amortization of premium or discount. If you received an original issue discount (OID), meaning you purchased the municipal bond on the primary market for a price below the stated par value, the OID is treated as interest, which means it’s likewise exempt from federal tax.

Certain municipal bonds can be taxable at the federal level, so it’s important to understand the type of investment you hold. Build America Bonds (BAB’s) are state and local government obligations issued in 2009 and 2010 for capital projects that are directly subsidized by the U.S. Treasury. BAB’s are taxable municipal bonds for federal purposes. Other state obligations can be taxable too if the federal government will not subsidize the debt due to lack of significant benefit to the general public.

Certain mutual funds, typically thought of as equity securities, can also produce tax-exempt income. If the underlying assets in a mutual fund are municipal obligations that would be tax-exempt if held directly, a portion of the income derived from the fund would be exempt from federal tax. Income from mutual funds is generally thought of as dividends, so you should consult your investment custodian, tax advisor and the fund literature to help determine an accurate understanding of the source of income.

As with most things tax-related, it’s important to highlight a few additional considerations. Although municipal bond income is generally exempt from federal taxes, it’s not always that straightforward. Because this is a tax preferential income source at the federal level, it’s generally added back when computing income subject to Alternative Minimum Tax (AMT). As such, if a significant portion of your total invested assets are in municipal bonds and you become subject to AMT, you theoretically could be subject to federal tax on these investments. Municipal bond income can also be exempt from state income taxes if the bond is issued in the same state where you are subject to state-level taxes. However, if your state tax obligation is to a different state than which issued the bond, this is typically taxable at the state level.

If you have any questions on navigating the tax implications of your municipal investments, please contact us.


Matt Gravelin
Matt Gravelin | Principal