February 10, 2017
Many investors understand that bonds issued by states and municipalities are tax-exempt, and not subject to federal income tax. This status makes the bonds particularly attractive to taxpayers who are in higher tax brackets, as the after-tax returns of these bonds are often very attractive. However, there are times that these bonds may not be as beneficial as you think they are.
In 1979, the modern “Alternative Minimum Tax” system was created by Congress as an alternative tax system to make sure that certain high-income taxpayer paid their “fair share” of tax. This system works in tandem with the regular tax system – you pay the higher of the two taxes when you file your tax return. Originally, the AMT only affected a handful of taxpayers, but that number rose steadily, and now it is estimated to affect around 5 million taxpayers ever year. Because this tax system disallows dependent exemptions and state and local tax deductions, families with children who live in high-tax states are the mostly likely group of people to be subjected to this tax. The AMT also commonly affects investors that have substantial investment real estate holdings, investment expenses, and capital gains.
If you are not careful when investing in tax-exempt bonds, you may be purchasing bonds that are so-called “private activity bonds”. These bonds are securities issued by a state or local government to finance housing projects, stadiums, and other privately owned projects. While these bonds are tax-exempt for the regular tax system, they are added back for AMT purposes. If you are hit by the AMT, these bonds really aren’t tax exempt. To avoid this, carefully examine any fund prospectus that you are considering investing in, to make sure there aren’t significant private activity bond holdings. If you are investing in individual bonds, make sure you aren’t buying these bonds.
On the other side – if you aren’t in AMT and are otherwise planning to buy muni bonds, you may want to strongly consider looking at private activity bonds, as their yields are often slightly higher.
Another way that tax-exempt bonds can bite you is with the taxation of Social Security benefits. While tax-exempt bonds are generally free from federal income tax, income on these bonds is considered part of your Modified Adjusted Gross Income (MAGI), and could cause up to 85% of your Social Security benefits to be taxable, depending on your income levels.
Finally, just because a bond is exempt from federal income tax doesn’t mean it is exempt from state income tax. While I'm fortunate to live in the great state of South Dakota with no income tax, 43 out of 50 states have income taxes. Depending on where you live, you may have certain “double exempt” bonds available that are exempt from both federal and state income taxes. However, most tax-exempt bonds are taxable for state income tax purposes.
When in doubt – consult your tax advisor! The tax system is incredibly complex, and there are times it can have unexpected outcomes.
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