Municipal Bond Interest vs. Stock Dividends in Taxes

Instructor: Ian Lord

Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.

In this lesson we will review how municipal bond interest and stock dividends are taxed and identify some of the circumstances where the tax rate changes based on factors such as residency or length of ownership.

Tax Treatment of Municipal Bond Interest and Stock Dividends

Connor has run out of tax-sheltered retirement investing space and wants to find investments which still minimize his tax bill. Two options that have come across his desk are municipal bonds and dividend-paying stocks. Let's review with Connor how these investments are taxed so he has a better understanding of the tax consequences of his choices.

Municipal Bonds

A municipal bond is a bond issued by a city, county, or state government, often for the purposes of financing infrastructure projects. They are often called 'muni bonds' for short. A state might issue a bond to expand a university campus, or a city might need to raise money to build more hospitals and schools. As with other government bonds, the government agrees to pay periodic interest payments for a certain number of years before returning the invested principal.

Muni bond interest is generally not taxed at the federal level. An investor subject to the Alternate Minimum Tax might have to pay taxes on the interest from some muni bonds. If Connor buys a muni bond and lives in the same state where the bond is issued, he will not pay state or local taxes on the interest the bond pays him. If he owns muni bonds issued by other states, he may have to pay taxes on the interest to his home state according to that state's specific tax laws.

Stock dividends

Stock dividends are the portions of corporate profits paid out to shareholders. Investors like Connor prefer dividends to earned income from a job because of better tax rates. The tax rate depends on three factors; whether or not the dividends are considered qualified dividends according to the IRS, how long Connor has owned the stock, and Connor's tax bracket.

For the 2016 tax year, the tax brackets are 10%, 15%, 25%, 28%, 33%, 35% and 39.60%. If Connor owns a dividend-paying stock for less than one year, he owes taxes equal to his bracket. For example, if Connor buys stock on Feb 1st, receives $1,000 in dividends on July 1, and sells the stock a month later he will owe $250 if he is in the 25% tax bracket.

When an investor owns a stock for more than one year, the preferential tax treatment kicks in. A qualified dividend is a dividend paid by a U.S. corporation or qualified foreign corporation, which applies to most stock dividends in the United States. If an investor receives unqualified dividends, then the regular tax bracket applies the same as for stocks which have been owned for less than one year.

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