Beginning in 2013, there’s an extra tax incentive for investing in municipal bonds (munis).
Strategy: Include more munis in your portfolio to sidestep the new 3.8% Medicare surtax.
Here’s the whole story: Historically, investors have been encouraged to invest in munis due to three significant tax breaks.
- The interest income earned by munis is exempt from federal income tax. For example, if you’re in the 25% tax bracket and you earn a 6% return on a $1,000 investment, you normally realize a 4.5% after-tax return. In comparison, there’s no tax federal income dilution with investments in munis (see chart below).
- The interest income earned by munis may also be exempt from state income if the bonds are issued by an authority within the state where you reside. This further increases the after-tax return on certain bonds.
- The interest income earned by munis generally does not count toward your AGI. Therefore, the tax exemptions can provide other tax benefits on your personal tax return.
These three tax breaks haven’t changed. But now there’s a fourth tax reason to invest in munis. Beginning in 2013, a new 3.8% Medicare surtax applies to the lesser of your “net investment income” (NII) or your modified adjusted gross income (MAGI) above $200,000 for single filers and $250,000 for joint filers.
Key point: Munis don’t count as NII for this purpose nor do they increase your MAGI. Conversely, counting the 3.8% surtax and state income taxes, your overall tax rate on some income could exceed 50%!
Of course, there’s no such thing as a “free lunch.” Consider the potential downsides of investments in munis, including the following:
- Income from certain “private activity” bonds is an adjustment item for the alternative minimum tax (AMT). This could force you to pay the AMT instead of regular income tax or increase your existing AMT liability.
- The interest income received from munis issued by an entity in another state is subject to state income tax in your state. The state tax exemption only applies to munis in your home state.
- There’s no tax benefit if you sell a muni purchased at a premium. For instance, if you buy a muni for $10,500 that will be worth $10,000 if you hold it until maturity, you can’t subsequently claim a $500 loss on your tax return. The premium must be amortized over time.
- If you sell a muni at a profit, you must pay capital gains tax on the sale. Suppose you acquire a muni with a face value of $10,000 and sell it for $11,000. The $1,000 gain is taxable as a capital gain.
- If you sell a discounted muni, your profit is taxed as ordinary income to the extent of the accrued discount. Suppose you pay $9,500 for a muni with a face value of $10,000 and a maturity of 10 years. If you sell the bond for $9,800 after five years, $250 of the $300 gain is taxed as ordinary income. The remaining $50 is taxed as capital gain.
- The calculation of the tax on Social Security benefits includes tax-free municipal bond income. Depending on your situation, up to 85% of the benefits received may be subject to federal income tax. Check with your tax pro.
Tip: Instead of “going all in” on individual munis, you can invest in a municipal bond fund that provides the same basic tax benefits.
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