Although municipal bonds pay interest that is generally exempt from federal and state income taxes, it’s not always free from all taxes. We identify some of the taxes that could apply if you buy municipal bonds and next steps you may want to consider.

WHO issues tax-exempt municipal bonds?

The interest on bonds issued by state and local governments is generally tax-exempt at the federal level, unless more than 10% of the proceeds are used for trade or business activities by nongovernmental entities, including leasing a public building to a private entity for business use.

At what tax rate do municipal bonds make sense?

That’s your tax-equivalent yield—your muni tipping point, so to speak. It means that, with everything else such as maturity and rating being equal, a taxable bond has to yield more than 3.67 percent to make more sense than the 2.5 percent tax-exempt bond for someone in your tax bracket.

What are the tax advantages to owning municipal bonds?

Overview of Municipal Bonds For an investor, one of the major advantages of munis is that they are typically exempt from federal income tax. These debt securities are often excused from local and state tax as well, particularly when the bond’s investor lives in the state in which the bond was issued.

Is the interest on a municipal bond tax free?

Tax-free municipal bond interest is free from federal income tax, but private activity municipal bond interest is subject to AMT. Private activity municipal bond interest is tax free unless the issue is a taxable municipal bond. Private activity municipal bonds are bonds used to finance bridges, hospitals, private universities, and airports.

How to calculate tax equivalent yield on municipal bonds?

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.

How to decide between municipal bonds and corporate bonds?

Deciding between corporate or municipal bonds means you need to find a way to equalize the two yields in order to compare them. You can do this using something known as taxable equivalent yield. Tax Exempt Yield ÷ (1 – highest tax rate applied to investor earnings). To understand what this looks like, consider an example.

How to find out if a municipal bond is subject to Amt?

What you can do: For bonds held at Schwab, you can find out if a municipal bond is subject to AMT by accessing the “Research” page after logging into schwab.com, searching for a municipal bond and viewing its “Security Description” page. You can also contact a Schwab Fixed Income Specialist at 877-566-7982. 3.