Federal Taxation On Municipal Bonds
Municipal bonds are a type of debt obligations that are issued by local governments of states, cities and counties to raise money to fund public infrastructure projections like construction of hospitals, schools, universities, roads, highways, and sewers. |
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Many times investors shy away from municipal bonds because of the lower yield offered by them. However, compared to other bonds that pay interest payments that are taxable, one can actually benefit from municipal bonds. Municipal bonds offer more net interest income compared to other taxable bonds that have higher yields.
Usually interest payments from municipal bonds are exempt from federal taxes. Therefore, an investor does not have to pay federal income tax on the interest dividends that he receives. And, if the investor lives in the same state where the municipal bonds were issued, then he would not have to pay even state income tax and local income tax.
This means that even though municipal bonds have lower interest rate compared to taxable bonds, the returns are much higher since the investor does not have to pay federal income tax and sometimes state and local taxes.
However, an investor should be warned at if the individual comes under the alternative minimum tax (AMT) bracket, then he would have to pay the AMT to the federal and/or the state government
In addition, if the investor decides to sell the municipal bonds before the maturity date and he realizes capital gains, he would have to pay taxes on those gains both to the federal government as well as to the state government. However, capital losses can be offset against capital gains.
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