 Personal Finance PowerPoint Presentation. Municipal Bonds. Prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia. How are municipal bonds taxed, which you can find online. Take a look at the references, resources, continue your research from there. This by J.B. Maverick, updated January 17, 2022. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, and keeping that in mind. We're now asking the question, how are municipal bonds taxed? A bond is a debt security issued by a company or government to raise money and cover spending needs. So it's kind of similar to basically a promissory note, where basically you're going to in essence lend them money. They're going to give you the bond. The bond will typically have a maturity date and give you a return for lending them money in the form of interest. Oftentimes when we think of bonds from an investment strategy, we think about the government bonds because those are going to be the more secure type of investments. But of course there are company bonds and all other different kinds of bond structures that we can imagine to be set up. A municipal bond, also known as a mini, is debt security used to fund capital expenditures for a county, municipality, or state. So now we've got the government bonds, but we're talking about the bonds for the minis that are related to the county, municipalities, and states. Possibly not as secure as you would think the federal bonds, the U.S. government federal bonds are often thought to be quite secure because they're backed by the U.S. government. The U.S. government having more security possibly than a county, municipality, and state import because they've got the printing press over there, right? But you would still think that the state bonds and county bonds oftentimes would be more secure investments possibly than investing, say, in equities, for example, on a general basis, although it is dependent upon the county, municipality, or state. So municipal bonds are commonly tax-free at the federal level, but can be taxed at state or local income tax levels or under certain circumstances. So notice that the government are the people that are imposing the tax. So one way they're the ones that want the money, right? We're paying the county, the municipality, the state one way they can incentivize us investing in their bonds as opposed to investing in, say, corporate bonds is to remove the tax on it, right? So that would mean that the returns on those types of bonds could jump up or be a little bit more favorable. Obviously, when you think about those tax favorabilities in terms of the market, you would think that it would also be priced into basically the market as well. So when we're comparing different kinds of investment tools, different kinds of bonds, we've got to take that into consideration as well, meaning there's that little tax wrinkle that's a little bit different than when we compare to other, say, taxable bonds that we have to take into consideration, adding a little bit of complexity to our decision making process. So other overview of municipal bonds for an investor, one of the major advantages of many is that they are typically exempt from federal income tax. This debt securities are often excused from local and state tax as well, particularly when bonds investors lives in the state in which the bond was issued. So if you're in the state, the bond was issued possibly more likely that it will be taxable, non-taxable, not only on the Fed, but on the state level. When we say non-taxable, we're typically talking about, of course, the interest, the earnings, because when you buy the bond, you're paying money out. You're not going to have a tax implication when you're paying the money or you're investing the money. Typically, when will the tax be triggered? When you're earning, when is that going to happen as interest basically accumulates? And that's the question as to whether it's something you have to report on your taxes, which would mean that it would then be a taxable event possibly at that time. Essentially, unless you're excused from it, which would be the benefit of some of the corporate, of the munis. So essentially, when investors buy a municipal bond, they loan money to the bonds issuer in exchange for a specified number of interest payments over a set period of time. So it's similar to like a promissory note. We're loaning money. We're getting basically like the note, which is kind of like a bond in return, which is going to have a fixed set of rent on the note. We're loaning money just like when you loan or rent a home. For example, rent an apartment. You pay for the use of it. Well, if the government's renting basically our purchasing power of the money, they're going to pay rent in the form of the interest that we agree on in the terms of the bonds. So the end of this period is referred to as the bonds maturity date. So typically, just like when you sign a rental contract or something like that, at the end you've got the maturity date in which you have to return the property, in this case the property being the money that we loaned to the government that would have to be returned to us at the end of the time frame, defined as when the investor's full investment principle is returned. So they're going to have to give it back to us, what we gave them, because we only loaned it to them. They're going to give it back to us. Municipal bonds because they are tax exempt and popular among individuals in higher income brackets. So the tax savings, it's kind of an interesting calculation on how it will work because noting that the tax implications will have different impacts depending on how much we earn because of the progressive tax system. So that would mean that our higher income levels, the fact that we have this non-taxable component, might be a more advantageous thing when we're talking about the higher income earners as opposed to the lower income earners. So again, this tax implication, taxes always complicate the situation. Progressive income tax will complicate the decision as to what will be the impact of that tax-free component compared to other kinds of investments, other kinds of bonds, which would be taxable. While duties are generally assumed to be tax-free, investors should determine a bond's tax consequences before investing. If an individual invests in a bond issued by an agency of their home state, there is rarely state tax charged. However, if they buy the bonds of another state, their home state may tax their interest income from the bond. So while the interest income is usually tax exempt from municipal bonds, capital gains realized from selling bond are subject to federal and state taxes. So in other words, if we buy the bond, then when we pay the promissory note, when we make interest on it, that interest is typically not taxable. But we could also simply sell the bond, which could go up in price. If the bond basically goes up in price, then when we sell the bond, if we sell it at a gain, now we've got another kind of income, that would be a capital gain. That would be not us holding the bond till maturity, just owning or getting the rental income, the interest on it, but rather a capital gain on the sale, which could trigger a taxable event. So the short-term or long-term capital gain or loss on the bond sale is the difference between the selling price of the bond and the original purchase price of the bond. Municipal bonds and capital gains, when buying duties on the secondary market, meaning secondary market would mean if the bond issuer, in this case being the state, for example, issuing the bond, issues them directly to the investor, you're buying it basically on the primary market, or you can of course have people, just like we said, selling the bond that we already purchased from the primary market. That's the secondary market here. So investors must be aware that bonds purchased at a discount, less than the par value, will be taxed upon redemption at the capital gains rate. Note that this tax does not apply to coupon payments, only the principle of the bond. For example, the table below shows three different bonds all maturing in two years and all of which give the buyer a return of 4% if purchased at their net present value. So I don't want to spend too much time on this because it's getting a little bit into the weeds, a little bit of complication here, but let's just give a quick recap. We've got the bond one at par, one premium, one discount. We've got the required rate of return, which you can think about as basically the market rate of return being the same for the all three, the coupon rate, which is the rate on the face amount of the bond. Now remember, if you're buying on the secondary market, then the coupon rate, the amount of rate on the bond is already been set. If you can think about it as being written on the bond, you can't change that. That's different than if you were to take a loan from the bank, for example, or if you were to loan money from the bank, they would adjust the interest rate, but you can't adjust the interest rate of the bond on the secondary market because it's on the bond. Therefore, you're going to be adjusting the price. Now, if these two things were the same, which they typically would be when the bond was issued on the primary market, for example, then you've got the cash flow at the end of the year, which is going to be the 4% cash flow at the end of year two. Coupon and principal, it's going to be the 104%. So the net present value then is going to be 100 because these two things are the same. We're assuming it's a $100 bond. So if we got the premium, then now we've got the market rate at the 4%, but the coupon rate is 6%, meaning the rate on the bond is actually paying higher than the market or what you can get somewhere else on the market. So that means that you can't adjust the interest rate to down to 4%, so you're going to have to adjust basically the price on the bond to compensate for the fact that you're getting a return higher than what you can get on the market for similar types of bonds. So cash flow at the end of the year, we're going to say 6%. Cash flow at the end of year two, coupon and principal, 106%. Therefore, the net present value is going to be 103.77. I'm not going to get into the detail of calculating that right now, but just note that we're issuing it for something higher than basically the face amount of the bond because it has, it's paying out 6% and that's higher than the current basically required rate return or market return of 4%. A discount then if we have the required rate return market rate at the 4%, but the bond itself has 2% on it because when they issued the bond, it was at 2% at that point in time. Again, we can't basically increase the percent to 4% to match the current market for similar types of investments and therefore we're going to have to adjust the price. So if we have a cash flow at the end of the year is $2, so then we have 100 into the net present value is 96.22. I'm not going to get into the detail of how to calculate this, but just note that now the 96.22 is what we had to adjust instead of the interest and that is now below basically the face amount of the bond because you've received 102 and it's the difference between these two rates, market rate, in other words required rate of return and the coupon rate, the rate on the actual bond that is resulting in some of that complexities. The difference between the net present value and the principal payment at maturity is taxed at a capital gains rate of 15%. In this case, the discount bond from above will be worth less to the buyer as shown below. So let's go back up to the slide above just to get a handle on this. This one that was purchased at a discount means that it was purchased for something less than the face amount, which we're thinking was the $100 due to the fact that the rate on the bond, the coupon rate is less than basically the market rate what we can get from similar bonds, for example. The fact that we purchased it for something less than the face amount of the bond could mean that we have tax consequences on that. If we take that into consideration, for example, the tax consequences could be calculated thusly. We've got the 100 face amount of the bond minus the 95.62 is the 4.38. If we multiply that times the rate which we're assuming is 0.15 or 15%, we get the 0.657. If we subtract that from the 102, so we're going to say minus the 102, we really have the cash flow at the end of year two, coupon plus the principal minus the tax of the 101.34, which adjusts the real net present value after considering taxes to the 95.62. So I know that's kind of getting into the weeds, but again, just to point out that the taxes do complicate when we're trying to make different comparisons of items that have a taxable component and those that do not. An investor could end up paying $96.22 for a bond that is only worth $95.62 without knowing that the gain is subject to capital gains tax. Now, a couple things to note here. One, you might say that's not a big difference. I'm not very concerned with that difference. But obviously usually we don't buy just one bond, but we would buy multiple bonds. And if we take that difference and expand it out to a large investment, it can be a significant factor. And two, a lot of the individual investors may not be purchasing say bond for bond, for example, but possibly it purchasing mutual funds that have bond component and exposure to it. So may not be getting so much into the weeds like for these types of calculations on a bond by bond calculation. But do you want to have a general understanding, a broad understanding of the tax consequences of bonds that could fit into their tax planning strategy, depending in part on upon their income level. So the bad news that is that while discount bonds are taxed, bonds purchased at a premium do not work similarly. They cannot offset capital gains by providing capital losses. So you would think that the opposite would be true when you pay a premium on the bond because now you're paying more than the face amount of the bond. But no, so the tax rule runs contrary to that of most investments including other types of bonds because the Internal Revenue Service treats tax-free instruments differently than their taxable counterparts. Therefore, when analyzing yields for many bonds offered on the secondary market, the yield to maturity figure is usually sufficient to determine an expected return. For discount bonds, one must also factor in the negative tax implications that can arise from capital gains. Municipal bonds and de minimis. So one of the most confusing concepts relating to many duty bonds is the de minimis tax rule. This negative tax law states that if you purchase a bond at discount and the discount is equal to or greater than the quarter point per year until maturity, then the gain you realize at the redemption of the bond, a par value minus purchase price, will be taxed at ordinary income, not as capital gains. So now we're getting into the weeds again in terms of the types of taxation because the whole point of purchasing the munis or part of it, part of the incentive being that you get this tax incentive component. And now we're saying, well, there could be certain situations where you have a discounted bond, where you might be subject to capital gains, which is bad enough. But if you're subject to ordinary income gains, now we're talking about different kinds of income tax, that capital gains usually have a preferred rate over ordinary income. So if you had the choice of being taxed at all, you would rather be taxed generally at the capital gains rates, which are typically lower than the ordinary income rates. So this could mean the difference between paying 15% and 37% on the gain for those at the top of the tax bracket. So for example, let's take the discount bond from the previous example, because it is two-year bond, we can calculate that purchasing it for $99.50 or less will mean falling into the de minimis rule and being taxed at the ordinary income tax rate. So since the net present value for this bond is well below $99.50, we need to calculate the tax consequences with the gain on the principal is taxed at ordinary income as indicated here. So I won't go into that in more detail, but keep that in mind. Let's get a little far into the weeds here. Well, an investor might pay $95.62. If you're only accounting for capital gains tax, the true value is much lower, only $94.73. At the time of purchase, the buyer must recognize whether the bond is subject to de minimis because the after tax return could be substantially less than expected. So we have to get the proper rate for trying to figure out what the proper tax consequences would be, which again, taxes get quite confusing when we got these different rates, income capital gain and when it's going to be applied and comparing that to other types of investments. So don't have the same tax consequences. So municipal bonds and federal taxes, the federal government does not tax most activities of state and municipalities, therefore giving most muni bonds tax exempt status. However, some activities do not fall under this tax exemption. For instance, coupon payments for many bonds sold to fund those activities are federally taxed. With one common example is a bond issued to fund a state's pension plan obligations. So when this type of bond is for sale brokers selling the bond should readily know whether it is taxable. Another more harrowing example of taxable munis are those that are issued as tax free, then later become taxable if and when the IRS determines the proceeds are being used for purchases that do not fall under tax exempt status. So obviously on the federal tax side of things, they're going to say they're trying to influence what the state is going to be basically using the money for. And it would be a bad thing, but you can see we're under the tax law here that something at one point could be under non taxable, for example, and then they changed the law and that would be a problematic thing for many taxpayers, but it's possible to take place. This is very rare, but when it happens, it leaves a lot of very unhappy investors clearly. Their coupon payments are taxed as ordinary income, and if they choose to sell the bond, the price they receive will be reduced because buyers would require a higher yield on taxable bond. Generally, taxable munis are still exempt from state and local taxes as investors in states with higher income taxes may find that they get a better after tax return than with other fixed income investments that are fully taxable at all levels, such as corporate bonds or certificates of deposits, the alternative minimum tax. Although it is relatively uncommon, some muni bonds are federally taxed if the holder is subject to alternative minimum tax, typically a type of tax that's subject to higher income individuals for the most part. So, if you are unsure whether a specific muni is subject to AMT alternative minimum tax, consult the broker before purchase. For example, a bond that is used for a particular municipal improvement that is not backed by the credit of a state or municipality, but rather that of a corporation such as an airline backing an airport improvement bond would be subject to AMT. This would be zero coupon muni bonds, zero coupon municipal bonds, which are bought at a discount because they do not make any interest or coupon payments, don't have to be taxed. In fact, most aren't. As long as you're investing in a local municipal bond, taxes won't be a concern. This provides a big advantage over taxable bonds even with lower interest. To determine whether or not a tax-free bond is a better option than a taxable bond, simply apply the tax equation yield, tax equivalent yield, that's the TEY formula. You might talk about that more in a future presentation. Another important note here is that you will likely be subject to a capital gain or loss if you sell the bond before it matures. If you sell higher than the adjusted issue price, you look at a capital gain. If you sell for less than the adjusted price, you suffer a capital loss, which can be utilized to reduce overall tax bill. The biggest and most obvious benefit of zero coupon bonds is that you're buying the bond at a big discount to its face value. This is also known as the original issue discount or OID. For example, you can buy a $1,000 bond for $500. However, most zero coupon municipal bonds are sold in denominations of $5,000. Either way, you're buying at a tremendous discount. Thus, in return, allows you to buy more bonds if you so desire. The longer the bond has to mature, the bigger the discount you will receive. Of course, you have to hold up your end of the bargain to see the greatest benefits. And that simply means that you must remain patient until bond matures. By doing so, you will see a substantial return that's also tax-free. If you're the type of person who does not like guesswork or worry about economic conditions, it is worth considering zero coupon municipality bond because you will receive one payment at maturity, which is based on the principal investment plus the interest earned, compounded semi-annually at a predetermined rate. It's not going to be subject to the market fluctuation because you've locked in. Zero coupon municipal bond matures between 8 and 20 years. If you're a risk-averse investor and you're looking toward retirement, then it's highly recommended that you discuss zero coupon municipal bonds with your financial advisor. Municipal bonds are one of the safest investments you will find with the average default rate at 0.08% between 1970 and 2019, according to an annual study by Moody's credit agencies. Indeed, most zero coupon municipal bonds are rated A or higher by the rating agencies, but it's still important to check the quality of the issuer. So you would think they would have a high rating because they're kind of in the government bonds, but you still want to kind of check it out. Some places are in better shape than others. So if you're unconcerned or questioning whether or not you made a good decision, you can ease your mind by purchasing insurance for the bond. What is the distinguishing feature of how municipal bonds are taxed? Municipal bonds are free from federal taxes and are often free from state taxes if the bond purchased is from a state other than the purchaser state of residence. The home state may levy a tax on the bond's interest income. Alternatively, if the bond holder sells the bond and there is a gain, they are subject to a capital gains tax. Also, when bonds are purchased at a discount on the secondary market, capital gains tax may apply when the bond is redeemed. What happens to Moody's prices when taxes increase? Because municipal bonds are generally free from taxes, they become an attractive investment when taxes increase. And for Moody's increases and as a result, so do their prices. So how are state municipal bonds taxed? Municipal bonds issued by state are free from federal taxes and are often free from taxes from the state that issued the bond. Moody's are often free from state taxes if the bond issuer is not in the purchaser state of residence. However, in states like Oklahoma, Illinois, Iowa, Wisconsin, interest income is taxable for residents. In states with no income tax, purchasers can purchase munis from any state without a state tax obligation. Do municipal bonds show up on 1099 tax forms? Form 1099 INT reports interest from municipal bonds. So typically you're going to get that good old 1099 to help you out to determine if something's going to be taxable or not. Although reported federal taxes are not due, our municipal bonds need ETFs tax-exempt. So now you're thinking about the ETF, a format of purchasing or investing in these types of bonds, for example. Municipal bond ETFs are generally free from federal and state taxes if they hold only tax-exempt bonds. However, if the municipal bond ETF has a combination of tax-free and taxable interest, taxes may be due on the federal and state level. How do I buy tax-free municipal bonds? Municipal bonds can be purchased from a broker, dealer, or bank that deals with municipal securities from an investment advisor through a self-managed account or in a mini-mutual fund or exchange-traded fund. That's the ETF. What's the bottom line? While traditional or zero-coupon municipal bonds are an attractive investment for many due to the tax savings, you must understand the potential tax liabilities before making a purchase. In the absence of proper due diligence, you may be surprised by unexpected tax bill.