Tax Implications

Lesson

Municipal bonds are generally exempt from federal income tax and may also be exempt from state and local taxes.

Practice Question #1

Which of the following is a characteristic of municipal bonds?

A) Subject to federal income tax

B) Issued by corporations

C) Exempt from state and local income taxes

D) Pay periodic interest

Select an option above to see an explanation here.

A) Municipal bonds are generally exempt from federal income tax. B) Municipal bonds are issued by state and local governments, not corporations. C) Municipal bonds are generally exempt from state and local income taxes. D) Some municipal bonds pay periodic interest, while others do not.

Terms

Municipal bonds:: Debt securities state and local governments issue to finance public projects.
Tax-exempt:: Income that is not subject to federal income tax.
Taxable municipal bonds:: Municipal bonds subject to federal income tax.
Double tax-exempt:: Municipal bonds exempt from federal and state income taxes.
Triple tax-exempt:: Municipal bonds exempt from federal, state, and local income taxes.

Practice Question #2

What is the taxable-equivalent yield?

A) The yield on a tax-exempt bond that would be required to produce the same after-tax yield as a taxable bond.

B) The yield on a taxable bond that would be required to produce the same after-tax yield as a tax-exempt bond.

C) The difference between the face value of a bond and its initial offering price.

D) The difference between the current market price of a bond and its face value.

Select an option above to see an explanation here.

A) This is the opposite of the taxable-equivalent yield. B) The taxable-equivalent yield is the taxable bond yield required to produce the same after-tax yield as a tax-exempt bond. C) This is the original issue discount (OID). D) This is the market discount.

Real-World Example

A high-income investor in California may choose to invest in a California municipal bond that is triple tax-exempt, meaning the interest income is exempt from federal, state, and local income taxes. This can provide a higher after-tax yield than a taxable bond with the same nominal yield.

Practice Question #3

Which of the following types of municipal bonds is exempt from federal income tax?

A) General obligation bonds

B) Revenue bonds

C) Both A and B

D) Neither A nor B

Select an option above to see an explanation here.

A) General obligation bonds are exempt from federal income tax because they are backed by the full faith and credit of the issuing municipality. B) Revenue bonds are also exempt from federal income tax because they are backed by the revenue generated from a specific project or facility. C) Both general obligation bonds and revenue bonds are exempt from federal income tax. D) Both types of municipal bonds are exempt from federal income tax, so this option is incorrect.

Rhyme

"Muni bonds, a tax break delight, for high-income folks, they're just right. Federal and state, taxes they evade, a wise investment choice, they've made."