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 bonds are debt securities that a city, county, or state issues to raise funding for a specific community-good project. Such projects often include water and sewer improvements, roadways, and public buildings.

Municipal bonds can be taxable or tax-exempt, with the latter designation being much more prevalent. These assets can be a smart addition to a taxable portfolio, because a portion or all of the income they generate can be exempt from taxation.

Here's what curious investors need to know about municipal bonds, including how they're taxed and how to accurately compare them to corporate bonds.

Key Takeaways

  • Municipal bond funds are mutual funds that are made up of municipal bonds, which are debt instruments issued by a government entity.
  • The earnings from municipal bonds are generally exempt from federal (and sometimes also state or local) taxes.
  • Municipal bond fund yields may be lower compared to that of other, corporate bonds, but the decreased yield can be offset by the tax savings.
  • The tax-equivalent yield is the pre-tax yield that a taxable bond must pay in order to equal the tax-free municipal bond yield.

What Are Municipal Bond Funds?

In general, a bond is a debt obligation issued by entities. You're essentially lending money to the entity, which promises to pay it back with interest. These entities may be corporations, or they may be government bodies. Municipal bonds, also called "munis," are a subset of bonds that are issued by government municipalities or their agencies.

If you're buying a government bond in the U.S. that doesn't come from the federal Treasury Department, then it's likely some form of municipal bond. It could come from a state government, a city, a county, or a public utility, for example.

These debt obligations are used to raise money to fund local projects, such as the building of schools, parks, and highways. 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?

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. The tax-free income opportunities could be extra-attractive to those who may be in a high tax bracket and want to reduce their tax burden.

The yields on municipal bonds are often lower in comparison to other bonds, such as those issued by corporations, though they may also be higher than those of comparable federal Treasury bonds. However, even when compared to higher-yielding corporate bonds, the tax benefits of municipal bonds can sometimes make up for the lower yields.

Determining Tax-Equivalent Yields

One way to help determine whether a municipal bond fund is the right investment for you is known as the "tax-equivalent yield." For example, a taxable bond, such as a corporate bond, that pays 5% may initially seem more attractive to an investor who also has the option to buy a tax-free municipal bond that pays 4%. However, to more accurately 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 that a municipal bond is paying 4%:

Tax-Equivalent Yield = .04 / (1 - .35) = 0.615, or 6.15%

This calculation reveals that the income tax savings of investing in the tax-free municipal bond are equivalent to a taxable bond earning 6.15%. If the taxable bond doesn't offer at least a 6.15% yield, then the municipal bond is likely a better deal for the investor seeking the most income.

Returning to the example scenario of choosing between a 4% muni bond and a 5% corporate bond, the bond investor may be wise to choose the tax-free 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.