Bonds can be purchased in both taxable and tax-exempt formats and you will find tax concepts to consider each time a person is purchasing bonds. Each kind of bond, whether tax-exempt or not, has different tax aspects. Tax-exempt municipal bonds and taxable bonds are discussed, explaining how some of the tax rules work for these investments and their investment yields.
Acquisition of Bonds
When purchasing tax-exempt municipal bonds at face value or par, you will find no instant tax consequences. Once the bond is acquired between interest payment dates, the client pays the vendor interest that has accrued since the last payment date. The interest paid beforehand to the vendor is treated as the expense of the investment and is treated basically as a get back of some the initial investment once the interest is paid.
Bond Premium Amortization
When tax-exempt municipal bonds are purchased at reduced, the premium is amortized for the duration of the bond term. The effect of this is to decrease the expense of the investment in the bond on a master rata basis. Thus, holding the bond to maturity means no loss recognized once the bond is paid off.
Interest Excluded From Taxable Income
Normally, tax-exempt municipal bond interest is not included with income for tax purposes (although, the interest may be taxable under alternative minimum tax rules). Also note, municipal bonds usually pay lower interest rates as compared to similar bonds that are taxable.
When you compare taxable investments to tax-free investments, the total amount of interest contained in income is not the main issue. What is important is the after-tax yield. For tax-exempt municipal bonds, the after-tax yield is usually equal to the pre-tax yield. On the other hand, a taxable bond's after-tax yield will soon be on the basis of the level of interest remaining after deducting the corresponding level of income tax expense related to the interest earned on a taxable bond.
The after tax return of a taxable bond depends upon a person's effective tax bracket. Generally, tax-free bonds are more desirable to taxpayers in higher brackets; the main benefit of not including interest earned within their taxable income is greater. In contrast for taxpayers in lower brackets, the tax benefit is less substantial. Although municipal bond interest is not taxable, the total amount of tax-exempt interest is reported on the return. Tax-free interest can be used to calculate the total amount social security benefits that are taxable. Tax-free interest also affects the computation of alternative minimum tax and the earned income credit. premium bonds UK invest
Tax-Free Interest is excluded from 3.8% NIIT
Tax-exempt municipal bonds interest can be exempt from the 3.8% net investment income tax (NIIT). The NIIT is compulsory on the investment income of individuals whose adjusted gross (AGI) is in excess of:
· $250,000 for filing status Married Filing Joint and Qualifying Widower,
· $125,000 for filing status Married Filing Separate, and
· $200,000 filing status Single and Head of Household.
Tax Advantaged Accounts
Purchasing municipal bonds in your regular IRA, SEP, or §401(k) is just a no-no. These accounts grow tax free and when withdrawals are made, the total amount withdrawn is taxable. Thus, if you want fixed income obligations in a tax advantaged account consider taxable bonds or similar income securities.
Alternative Minimum Tax Considerations
Interest on municipal bonds is usually not contained in income for regular federal income taxes. Interest earned on certain municipal bonds called "private activity bonds" is included in the calculation of alternative minimum tax (AMT). The AMT is a simultaneous tax system established to be sure that taxpayers pay the absolute minimum level of taxes. The intention of fabricating AMT was to prevent individuals from getting to many tax breaks, like tax-free interest. The tax breaks are added back to income and cause some individuals lose tax breaks and pay taxes.
Effects of Tax-Free Interest on Taxability of Social Security
A percentage of social security benefits are taxable when other income besides social security benefits surpasses certain amounts. For this reason, the total amount of taxable social security benefits adds tax-exempt interest into the total amount of other income received besides social security benefits to determine the total amount of taxable social security benefits. Consequently, if you get social security benefits, tax-free interest could increase the total amount of tax paid on social security benefits.
Effects of Tax-Free Interest on the Calculation of Earned Income Tax Credit
When a taxpayer is otherwise qualified to receive the earned income tax credit, the credit is lost completely once the taxpayer has significantly more than $3,400 (2015) of "disqualified income." Disqualified Income generally is investment income like dividends, interest -income, and tax-exempt income. Thus, having municipal bond fascination with excess of $3,400 causes a taxpayer to reduce the credit. However, a person qualified for the earned income tax credit is in a diminished tax bracket and an investment in municipal bonds would yield a diminished after tax return as compared to taxable bonds.
A Bond Sale or Redemption
Selling an attachment before maturity or redemption has the same tax consequences as a taxable bond. Gains from sale are taxable. Losses are deducted from other gains; and losses in excess of gains are allowed up to $3,000, the rest of the losses are carried to future years.
Selling Bonds Purchased At a Discount
Bonds acquired with "market discount", have special calculations then they're sold. The discount that accrued during the time maybe treated as ordinary income.
Mutual Funds
Some investors want professionals to manage a diversified portfolio of municipal bonds, to lower the default risk on any particular bond issue. There are certain mutual funds that spend money on tax-free municipals and manage them.
