Tax Treatment of Municipal Securities

Instructor: Bryant Trombly

Bryant has taught graduate finance and has an MBA and master's degree in information technology.

In this lesson you will learn about characteristics of taxable bonds, municipal bonds and their tax treatment, other taxable situations, and exceptions.


Gerald is a seasoned investor with a high income, and he generally finds himself in the top tax bracket each year. He has recently received a large bonus at work and wants to invest it in a conservative strategy for his upcoming retirement. While Gerald has some ideas about the types of securities he wants to invest in, he calls up his investment advisor Elenor to get her recommendations.

Gerald starts off the conversation by mentioning he would like to buy some bonds. Bonds are debt securities where an investor lends an initial amount of money to a corporation called the principal for a set amount of years. Over those years the investor receives annual coupon payments, payments based on the interest rate of the bond. At the end of the set amount of years, the investor gets the principal amount back. Bonds have historically been a conservative option for investors.

He also mentions his concern about taxes. Elenor points out to Gerald that most bonds issued by corporations are taxable bonds which means the coupons he receives will be taxed as more income at his high tax bracket. She mentions that she has another idea for him to consider...

Municipal Bonds

Taxable bonds are issued by corporations but corporations are not the only bond issuers that investors can turn to. Elenor tells Gerald about municipal bonds which are bonds issued by states, counties, municipalities, and other government entities. Municipal bonds have a special Federal income tax status which means that investors do not have to pay federal taxes on the coupon payments they receive from the bonds.

On top of that, municipal bonds also have a special state and local tax status which means that if an investor pays taxes to the state or local government that issued the bonds then the coupon payments received are tax free on the state and local level also.

Gerald really likes hearing this idea. He can get his conservative investment strategy and not add to his taxable income too! Elenor gives Gerald an example to show him how this works. She takes out a piece of paper and begins to write down a scenario.

If Gerald were to buy a municipal bond issued by his state for $1000 and that bond had a 6% interest rate yield, he would receive a $60 coupon payment each year. Normally Gerald would have to pay 40% between federal and state taxes on the coupon but because this is a municipal bond from his state he owes none and gets to keep all $60.

Elenor asks Gerald if he knows what sort of yield he'd have to get on a taxable bond to keep the same $60 after taxes. When he pauses and says he's unsure Elenor shows him how to calculate the taxable equivalent yield which is the yield needed on a similar taxable bond to have the same outcome.

To find this Gerald just needs to use the following equation: ( Coupon / (1 - Tax Rate) ) / Bond Value

Gerald plugs in his numbers and gets the following: ( $40 / (1 - 40%) ) / $1000 = 10% for the taxable equivalent yield!

Other Taxable Situations

Investing in a municipal bond does not mean that Gerald will never have to pay taxes on his municipal investments. All municipal securities have a par value which is the initial value of a bond; this is most often $1000. When investors buy bonds from other investors, they sometimes buy them at a discount when the purchase price of a bond is below the par value or at a premium when the purchase price of the bond is above the par value.

If an investor gains or looses money by selling a bond for more or less then they purchased it for, they will owe taxes on the difference if the total of all of their transaction is a gain. For example, if Gerald buys three municipal bonds for $1000 each and sells two of them for $1100 each and one for $900 he will have made $100 + $100 - $100 = $100 and will be subject to tax on this gain.

Elenor also tells Gerald there are special municipal bonds sold by issuers that are known as original issue discount (OID) bonds which have no coupon payment but are sold at a discount to investors. In this case the difference between the discount and the selling value is not taxable because the discount acts the same as the special tax treatment a coupon would usually get.

If Gerald purchased a bond in between annual coupon payments, then Gerald would also pay the seller an extra amount known as accrued interest which is the portion of the coupon the seller should have received for the time that they owned the bond. This amount would be subject to the same special taxation rules as the coupon payment.


All of this sounds great, and a little confusing, to Gerald. He understands that in general the income he receives from a municipal bond will be tax free and any gains will be taxable. He asks Elenor if this is always true.

Elenor tells him that there are a few exceptions to every rule. The IRS has created a tax structure known as the Alternative Minimum Tax (AMT) for people who receive all or most of their income from what would normally be tax free sources like municipal bonds. The AMT ensures that they still pay some tax on these sources.

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