What Are Triple Tax Free Municipal Bonds?
Learn how your residency unlocks different levels of tax exemption on municipal bond interest and the key tax reporting considerations that still apply.
A municipal bond is a loan from an investor to a state or local government, which issues the bond to fund public projects like schools or highways. In exchange, the issuer pays the investor periodic interest and returns the principal amount at maturity. A primary feature of these bonds is that the interest income is often tax-advantaged. A “triple tax-free” bond offers the highest level of tax exemption, making it attractive for investors looking to manage their tax obligations.
The Three Levels of Tax Exemption
The tax benefits of municipal bonds are structured in layers. The first and most common benefit is the exemption from federal income tax. The interest paid by nearly all municipal bonds is not taxed by the federal government, and this exemption applies to investors in all fifty states, regardless of which municipality issued the bond.
The second level of tax exemption is from state income taxes, which depends on the investor’s state of residence. To receive an exemption from state taxes, an investor must purchase bonds issued by their own state or a municipality within it. If an investor buys a bond issued by another state, the interest is still federally tax-free but will likely be subject to their home state’s income tax.
The final layer is the exemption from local income taxes, which grants the bond “triple tax-free” status. This is only attainable for investors who live in a city or county that imposes its own local income tax and who purchase bonds issued by that specific locality. For instance, a resident of New York City who buys a bond issued by the City of New York would pay no federal, state, or city income tax on the interest. This level of exemption is rare because few municipalities levy a personal income tax.
How to Acquire Triple Tax Free Bonds
To invest in triple tax-free bonds, an individual must identify bonds that qualify based on their residency. The primary document for this is the bond’s official statement, which details the issuing authority, the purpose of the bond, its repayment source, and its tax status. Reviewing this statement confirms if the bond qualifies for the desired state and local tax exemptions.
There are two primary methods for purchasing these bonds: individually or through a fund. Individual bonds can be bought through a brokerage account, giving the investor direct ownership and control over the specific bonds in their portfolio. However, this approach may require a larger capital outlay and more research to ensure proper diversification and credit quality.
A more common method is to purchase shares in a municipal bond mutual fund or an exchange-traded fund (ETF). To achieve triple-tax-exempt status, an investor would need a “single-state” fund that holds bonds from their state. This approach offers diversification, professional management, and a lower minimum investment, with the tax-exempt income passed through to shareholders.
Tax Reporting and Key Considerations
Even when interest from a municipal bond is entirely tax-free, it must be reported to the Internal Revenue Service (IRS). Brokerage firms and fund companies report the total amount of tax-exempt interest received on Form 1099-INT in Box 8. This figure must then be entered on the investor’s federal tax return, Form 1040, on the line for tax-exempt interest.
It is important to distinguish between tax-exempt interest and taxable capital gains. The tax exemption applies only to the interest payments received while holding the bond. If an investor sells a municipal bond for a price higher than their purchase price, the profit is a capital gain. This gain is fully taxable and must be reported on Schedule D of the tax return.
Certain municipal bonds, known as “private activity bonds,” can have implications for the Alternative Minimum Tax (AMT). These bonds are issued by a government entity but finance projects for a private entity, such as an airport terminal or sports stadium. Interest from these specific bonds is a “tax preference item” reported in Box 9 of Form 1099-INT. For taxpayers subject to the AMT, a parallel tax system, this interest gets added back into their income, potentially increasing their tax liability.
The tax-exempt interest from municipal bonds can also affect the taxation of Social Security benefits. The IRS uses a “combined income” calculation to determine if a portion of a retiree’s benefits are taxable. This formula is Adjusted Gross Income (AGI) plus nontaxable interest plus one-half of Social Security benefits. Because tax-exempt interest is included in this calculation, it can push a retiree’s combined income over certain thresholds, causing up to 85% of their Social Security benefits to become taxable.