Taxation of Municipal Bond Funds

What Are Municipal Bond Funds and How Are They Taxed?

Arial view of the city of Denver downtown area which benefits from Municipal Bond Funds
••• Brad McGinley Photography / Getty Images

Municipal bond funds can be a smart addition to a taxable account because a portion or all of the income generated from these funds can be tax-exempt. Municipal bonds are debt securities that a city, county, or state issue to raise funding for a specific community-good project. Such projects often include water and sewer improvements, roadways, and public buildings. Unlike many other bond holdings, municipal bonds can return tax-free investment income.

What Are Municipal Bond Funds?

In general, a bond is a debt obligation—or loan—issued by entities, such as corporations or governments. Also called munis, municipal bonds are bonds that are issued by government municipalities or their agencies.

Examples include cities, states, and public utilities. The debt obligations are used to raise money to fund the building of schools, parks, highways, and other projects for public use. Municipal bond funds are mutual funds that invest primarily in municipal bonds.

How Are Municipal Bond Funds Taxed?

Municipal bond funds provide investors with interest that is exempt from federal income taxes. This income may also be exempt from state and local taxes for investors who reside in the issuing state or locality.

For example, a New York City bond could be triple-tax-free. That means it could be exempt from federal, state, and local taxes if the investor lives and pays taxes in New York City. For this reason, municipal bond funds are often referred to as "tax-free" or "tax-exempt" investments.

Who Should Invest in Municipal Bond Funds and Why?

Investors who should use municipal bond funds are primarily those who want to earn yields that are typically higher than that of money market funds and who may be in high tax brackets.

The yields on municipal bonds are often lower in comparison to other bonds, such as those issued by a corporation. However, the tax benefits of municipal bonds can make up for the lower yields.

Determining Tax-Equivalent Yields

But how do you know if a municipal bond fund is the best investment for you? The answer lies in what's called "tax-equivalent yield." For example, a taxable bond, such as a corporate bond, that pays 5% may not be as attractive to an investor buying a tax-free municipal bond that pays 4%. To determine which bond is best, the investor can calculate the tax-equivalent yield.

The tax-equivalent yield is the pre-tax yield that the taxable bond must pay in order to equal the tax-free municipal bond yield.

The calculation is the tax-free municipal bond yield divided by one, minus the investor's tax rate. Here's the calculation for an investor in the 35% marginal tax bracket, considering a municipal bond is paying 4%:

Tax-Equivalent Yield = .04 / (1 - .35) = 6.15 percent

This calculation reveals that the income taxes saved by using the tax-free municipal bond is equivalent to (the same as) a taxable bond earning 6.15%. Therefore the bond investor is wise to use the municipal bond or municipal bond instead of the taxable corporate bond.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.