Dirty Little Secrets about Your Tax-Free Municipal Bonds

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I love tax-free income. The great thing about tax-free municipal bonds is the tax-free part. The downside is that they usually pay a lower interest rate than taxable bonds. For many people, tax-free trumps taxable every time—but you have to be careful because they’re not always the best deal for everybody. This is what you need to know:

1. While municipal bonds are tax-free on your federal return, they may be taxable on your state return. Usually, if the municipal bond is for your own state, then it’s not taxable. For example, here in Missouri, if I buy a bond from St. Louis County—that’s not taxable on my Missouri return. But if I bought a tax-free bond from New Jersey, then I’d pay tax on that interest. Buying at home gives you better bang for your buck.

2. Even though your municipal bond interest isn’t taxable, it could make your Social Security income taxable instead. Say what? That sounds a little crazy, doesn’t it? Let’s say you’re a senior citizen with moderate income. You’ve got your social security check, a small pension, a little interest from a CD and a bank account, and most of your other cash tied up in tax-free municipal bonds. With social security income, you’ve got that funky formula where you take half of the social security and add it to the other income and if it crosses the threshold, then part of your social security benefits become taxable. Are you rolling your eyes yet? The computer does this all for you right? But – and this is the important part—your tax-free municipal bond interest gets added into that equation. If you’re one of those borderline seniors, that tax-free bond isn’t saving you as much money as you thought. You might want to look at other, higher return investments.

3. The dreaded AMT. If you’re a high income earner, tax-free income sounds like a great investment doesn’t it? But you’ve got to be careful if you’re dealing with the Alternative Minimum Tax. If you’re in the AMT zone, you want to stay away from what’s known as a “private activity bond.” A private activity bond is when a company like GM wants to raise money, but instead of GM issuing a bond itself, it has the local government issue a bond for it (for example for building a plant in the area). It’s still a tax-free municipal bond, but it’s actually for a private business so it’s called a private activity bond. If you’re an investor that doesn’t have to pay AMT taxes, you’re fine, you get all the benefits of tax-free income. If you’re paying AMT, then you’ve lost all the benefit of the tax-free income. Private activity bond income is taxable under AMT rules.

With the stock market going crazy and many people turning to bonds, it’s important to know the real tax effects of “tax-free” on your tax return.