Tax-Free Interest Isn’t Always Tax Free

Interest on municipal bonds is exempt from regular federal income tax. However, the interest may be taxable—directly or indirectly—under certain circumstances.

State income taxes

Not all states exempt municipal bond interest from their income taxes. Essentially, the tax rules for such interest fall into three categories:

• States that exempt interest on bonds of their own state but tax interest on out-of-state bonds (most states with state income taxes, including California and New York).
• States that exempt interest on all bonds, even those issued by other states (e.g., Utah exempts interest on out-of-state bonds if the issuer state exempts interest on Utah bonds). The District of Columbia exempts all interest.
• States that tax all municipal bond interest (in most cases Illinois, Iowa, Nebraska, Oklahoma, and Wisconsin).

Note: Interest on bonds issued by U.S. territories (e.g., the U.S. Virgin Islands) is tax free in all states because states are barred from taxing it.

Social Security benefits

Social Security benefits may be tax free or included in gross income at 50% or 85%. Having tax-exempt interest may trigger or increase federal income tax on Social Security benefits. The tax on Social Security benefits starts by adding to adjusted gross income one half of Social Security benefits plus all tax-free interest.

Dependency exemptions

In order to claim a dependency exemption for a qualifying relative, you must provide more than half of the dependent’s support. In figuring support, tax-exempt interest received by the dependent and used for his/her support can affect eligibility for claiming the exemption.

Premium tax credit

If you pay for private health coverage that you purchased through the Marketplace (i.e., do not have coverage through an employer or Medicare), you may be eligible for the premium tax credit to help pay for the coverage. Eligibility depends on household income (not on gross income, adjusted gross income, or taxable income). More specifically, household income is defined as modified adjusted gross income, which is adjusted gross income increased by any excluded foreign earned income, nontaxable Social Security benefits, and tax-free interest.

Alternative minimum tax

While exempt from regular federal income tax, interest on private activity municipal bonds (those used to build stadiums and other projects of a private user) is taxable for purposes of the alternative minimum tax (AMT). The only exemption: interest on private activity bonds issued in 2009 and 2010 are not taxed for regular and AMT purposes.

Conclusion

Owning municipal bonds may still be a savvy investment strategy for certain taxpayers. Those who choose to hold such bonds should be aware of the broader tax impact that the interest can have on their overall tax picture.

Source: Muni bond info on states from CCH State Handbook