The efforts that some people will make to avoid having to pay income tax are extraordinary. Yet some tax breaks sit in plain sight while the vast majority of taxpayers never use them to their advantage. One strategy to earn tax-free income is available to every single person in America, but fewer than one in 25 actually seize the opportunity each year.
For those who do, though, the payoff can be valuable. Below, we'll look more closely at the tax break that taxpayers use to earn almost $62 billion in tax-free income annually -- and whether it makes sense for you to use it as well.
The tax-free income source for everyone
Federal tax law provides that the income that qualifying municipal bonds issued by state and local governments pay is exempt from income tax. Ordinarily, bond income is included as taxable income and taxed at the same ordinary income rates as wage and salary income. However, the federal government recognizes the public good that can come from state and local governments engaging in public projects. By allowing investors not to pay tax on the interest from the municipal bonds that finance such projects, the federal government makes it cheaper for states and municipalities to borrow the money they need to move forward.
Specifically, investors are typically willing to accept lower interest rates on municipal bonds than they are on regular bonds with similar characteristics. That's because when you look at the net return on bonds after taking taxes into consideration, it takes a higher interest rate on a taxable bond to match what municipal bonds offer on an after-tax basis. For instance, if you pay taxes at a 25% rate, then a taxable bond that pays 4% interest only gives you 3% in after-tax income. The remaining percentage point goes to pay the tax. That makes a municipal bond yielding 3% equally attractive, because that return goes without any further taxation.
Double and triple tax-free bonds
Municipal bonds aren't just good for taxpayers are on their federal returns. Investors in municipal bonds that are issued by governments within their state generally also don't have to pay any state income tax on the interest, making such bonds double tax-free for in-state investors. New York City, Philadelphia, and a few other cities also have city income taxes, and bonds that those cities issue can also be exempt from those taxes, making them triple tax-free.
There are special rules for certain municipal bonds that territories and possessions of the U.S. issue. Such obligations are given the same triple tax-free treatment as in-state, in-city bonds, regardless of where an investor lives. That's what has made Puerto Rico bonds so popular in past years, as residents in any state could invest in them rather than stay close to home with their entire bond portfolios.
Why aren't municipal bonds more popular?
Given this source of tax-free income, it's surprising that so few people use municipal bonds to their advantage. Just over 5.8 million taxpayers claimed tax-exempt municipal bond interest on their tax returns during the most recent year for which IRS data is available, or 3.9% of the roughly 150 million tax returns that were filed in that year.
Yet the payoff for those who do choose to invest in municipal bonds can be considerable. Those returns claimed a total of almost $61.9 billion in tax-free interest. That works out to an average of $10,618 for every taxpayer who claimed the tax break. At the maximum rate of 39.6% that applied during that year, that worked out to more than $4,000 in federal tax savings, as well as potential state and local tax benefits as well.
One reason why municipal bonds aren't more popular is that many perceive their risk level as having gone up recently. High-profile financial difficulties in areas like Detroit, Illinois, and a number of cities and counties in California have raised awareness of the real risks of default on municipal bond obligations. As a result, there've been periods of time during which municipal bond rates were actually higher than those on Treasury bonds of comparable maturity, even though Treasury bonds are federally taxable. More recent troubles in Puerto Rico, which is one of the biggest issuers of municipal bonds, make it clear that these investments are far from risk-free.
Should you invest in municipal bonds?
Despite those risks, municipal bonds have benefits that make them attractive for people in many different situations. Even though lower tax rates will reduce the positive impact of earning exempt income, those who are in higher tax brackets should look closely to see if they might do better by shifting some of their bond exposure toward the municipal sector.