What Is Municipal Interest Income and How Is It Taxed?
Understand how municipal interest income is earned, its tax implications at the federal and state levels, and how to report it on your tax return.
Municipal interest income is a key consideration for investors seeking tax-advantaged returns. It comes from bonds issued by state and local governments, often appealing to those in higher tax brackets looking to reduce taxable income.
While municipal bond interest can offer tax benefits, taxation depends on federal and state policies. Understanding these rules helps investors make informed decisions when managing their portfolios.
Sources of This Income
Municipal interest income comes from bonds issued by state and local governments for various public projects. General obligation bonds, backed by a municipality’s tax revenues, carry lower risk since repayment is secured by the government’s taxing power. Revenue bonds, on the other hand, are repaid with income from specific projects like toll roads or utilities, making them riskier.
Private activity bonds finance private projects with public benefits, such as hospitals or housing developments. While they often provide tax advantages, some are subject to the alternative minimum tax (AMT), which can impact high-income individuals. Investors should confirm whether a bond falls into this category before purchasing.
Municipal bond funds and exchange-traded funds (ETFs) offer another way to earn tax-advantaged interest by pooling investments across multiple bonds, providing diversification. However, management fees and expenses can reduce overall returns, making cost comparison essential.
Federal Tax Treatment
Municipal bond interest is generally exempt from federal income tax, making it attractive for tax-efficient income. However, capital gains from selling a bond above its purchase price are subject to federal capital gains tax, with rates depending on the holding period.
Interest from certain private activity bonds may be subject to the AMT, which limits tax benefits for high-income individuals. In 2024, the AMT exemption threshold is $85,700 for single filers and $133,300 for married couples filing jointly. Investors exceeding these thresholds may owe additional taxes on AMT-subject municipal bond interest.
Buying municipal bonds at a discount can also have tax implications. If a bond is purchased below face value in the secondary market, the difference between the purchase price and redemption value may be taxable under the de minimis rule. If the discount exceeds 0.25% of the bond’s face value per year until maturity, the gain is taxed as ordinary income rather than capital gains.
State Variations
While municipal bond interest is exempt from federal taxation, state tax treatment varies. Many states exempt interest from bonds issued within their borders to encourage local investment. For example, a California resident holding California municipal bonds typically does not owe state income tax on the interest, but interest from bonds issued by other states may be taxable.
States without an income tax, such as Texas and Florida, do not tax municipal bond interest regardless of origin. In contrast, states like New York and Illinois tax interest from out-of-state municipal bonds while exempting their own, incentivizing residents to invest locally.
Some states impose additional rules. Minnesota taxes all municipal bond interest unless explicitly exempt under federal law. Indiana and Wisconsin partially tax interest from out-of-state bonds, reducing but not eliminating the tax benefit. Investors should review their state’s tax policies before purchasing municipal securities.
Reporting on Returns
Investors must report municipal bond interest on their tax returns, even if it is tax-exempt. The IRS requires this income to be disclosed on Form 1040, Line 2a. While it does not increase federal taxable income, failing to report it can trigger IRS scrutiny, as financial institutions issue Form 1099-INT for interest exceeding $10. Ensuring reported amounts match these forms helps avoid discrepancies that could lead to audits.
Municipal bond interest subject to the AMT must be reported separately on Form 6251, which determines if an individual’s tax liability is higher under the AMT framework. Investors holding AMT-subject bonds should review this form carefully to avoid underpayment penalties.
For bonds purchased at a discount, any taxable portion under the de minimis rule should be reported as ordinary income, typically on Schedule B. Accurate reporting ensures compliance and helps investors avoid penalties.