Bonds are available in both taxable and tax-exempt formats and you can find tax concepts to think about each time a person is purchasing bonds. Each form of bond, whether tax-exempt or not, has different tax aspects. Tax-exempt municipal bonds and taxable bonds are discussed, explaining how a number of the tax rules benefit these investments and their investment yields.
Acquisition of Bonds
When purchasing tax-exempt municipal bonds at face value or par, you can find no instant tax consequences. Once the bond is acquired between interest payment dates, the customer pays owner interest that's accrued since the last payment date. The interest paid beforehand to owner is treated as the price of the investment and is treated basically as a get back of some the original investment once the interest is paid.
Bond Premium Amortization
When tax-exempt municipal bonds are purchased at a premium, the premium is amortized for the duration of the bond term. The aftereffect of that is to decrease the price 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 put into income for tax purposes (although, the interest might be taxable under alternative minimum tax rules). Also note, municipal bonds usually pay lower interest rates as compared to similar bonds which can be taxable.
When comparing taxable investments to tax-free investments, the total amount of interest included in income is not the most important issue. What is important could be the after-tax yield. For tax-exempt municipal bonds, the after-tax yield is usually equal to the pre-tax yield. On one other hand, a taxable bond's after-tax yield will undoubtedly be based on the amount of interest remaining after deducting the corresponding amount of income tax expense connected with the interest earned on a taxable bond.
The after tax return of a taxable bond depends on a person's effective tax bracket. Generally, tax-free bonds are more appealing to taxpayers in higher brackets; the benefit of not including interest earned inside their taxable income is greater. On the other hand for taxpayers in lower brackets, the tax benefit is less substantial. Even though 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 quantity social security benefits which can be taxable. Tax-free interest also affects the computation of alternative minimum tax and the earned income credit. invest bonds
Tax-Free Interest is excluded from 3.8% NIIT
Tax-exempt municipal bonds interest is also exempt from the 3.8% net investment income tax (NIIT). The NIIT is compulsory on the investment income of an individual 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 a no-no. These accounts grow tax free and when withdrawals are created, the quantity withdrawn is taxable. Thus, if you would like 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 included 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 ensure that taxpayers pay the very least amount 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 into income and cause some individuals lose tax breaks and pay taxes.
Effects of Tax-Free Interest on Taxability of Social Security
A share of social security benefits are taxable when other income besides social security benefits surpasses certain amounts. For this purpose, 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 find out 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
Whenever a taxpayer is otherwise qualified for the earned income tax credit, the credit is lost completely once the taxpayer has a lot 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 interest in excess of $3,400 causes a taxpayer to reduce the credit. However, a person qualified for the earned income tax credit is in a lowered tax bracket and an investment in municipal bonds would yield a lowered after tax return as compared to taxable bonds.
A Bond Sale or Redemption
Selling a bond before maturity or redemption has the exact 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 as much as $3,000, the residual losses are carried over to future years.
Selling Bonds Purchased At a Discount
Bonds acquired with "market discount", have special calculations then they are sold. The discount that accrued during the period maybe treated as ordinary income.
Mutual Funds
Some investors want professionals to control a diversified portfolio of municipal bonds, to lessen the default risk on any particular bond issue. There are certain mutual funds that invest in tax-free municipals and manage them.
