Income investing

Don't Let These Muni Tax Traps Hurt Your Portfolio

The municipal bond market has been a strong performer over the past several years with the iShares S&P National AMT-Free Municipal Bond Fund (NYSE ARCA: MUB) moving up nearly 3% year to date with a 2.28% yield, as of July 8, 2016. Due to its growing popularity, investors that may not be familiar with the inner workings of the muni market may be at risk of making some costly mistakes when it comes to calculating after-tax yields and paying taxes.

In this article, we will take a look at some common muni bond tax traps that investors should be careful to avoid when buying and selling the asset class.

Income Taxes

Municipal bonds have become attractive because interest payments are usually exempt from local, state, and federal income taxes. This means that muni bonds have a higher after-tax yield than their Treasuries or corporate equivalents that don’t enjoy the same benefits.

However, these exemptions aren’t always the case. Some muni bonds are subject to federal taxes despite being in the municipal bond asset class. For example, muni bonds issued to pay for a state’s pension plan obligations are often subject to federal income taxes since they don’t directly benefit the public. Some muni bonds are even issued as tax-free bonds and later become taxable bonds, which means investors must pay close attention.

The Alternative Minimum Tax (AMT) is another instance where investors could end up paying federal income tax on a supposedly tax-free asset class. For instance, muni bonds that are backed by corporations are often subject to the AMT. Airport improvement bonds are a great example of a muni bond that may be subject to the AMT in instances where a corporation like an airline is guaranteeing the bond rather than a government.

Capital Gains Taxes

Municipal bonds may also be subjected to capital gains taxes in some instances. Most commonly, muni bonds that are purchased at a discount are taxed upon redemption at the capital gains rate. This tax applies to the principle of the bond rather than the interest payments since the investor was essentially capitalizing on a discount. Ironically, buying bonds at a premium doesn’t offset capital gains by providing capital losses.

The so-called “de minimum” rule also states that bonds purchased a discount greater than a quarter point per year until maturity will be taxed as ordinary income rather than capital gains. In practice, this could translate to paying 35% tax rather than a 15% tax.

Key Takeaways

Municipal bonds have been growing in popularity thanks to their tax-advantaged nature, but there are instances when investors may owe taxes. It’s important to watch out for these situations when purchasing muni bonds in order to avoid falling into costly tax traps.

In general, investors may want to consider AMT-free municipal bond ETFs as a way to avoid many of these issues while maintaining diversified exposure to the asset class. A great example of one of these ETFs is the iShares S&P National AMT-Free Muni Bond Fund (NYSE ARCA: MUB).