Bonds are available in both taxable and tax-exempt formats and you will find tax concepts to consider when a person is investing in bonds. Each kind of bond, whether tax-exempt or not, has different tax aspects. Tax-exempt municipal bonds and taxable bonds are discussed, explaining how a number of the tax rules benefit these investments and their investment yields.
Acquisition of Bonds
When purchasing tax-exempt municipal bonds at face value or par, you will find no instant tax consequences. Once the bond is acquired between interest payment dates, the client pays the seller interest that's accrued since the last payment date. The interest paid ahead of time to the seller is treated as the expense of the investment and is treated basically as a reunite of some the original investment when the interest is paid.
Bond Premium Amortization
When tax-exempt municipal bonds are purchased at reasonably limited, the premium is amortized for the duration of the bond term. The effect of that is to decrease the expense of the investment in the bond on a pro rata basis. Thus, holding the bond to maturity means no loss recognized when the bond is paid off.
Interest Excluded From Taxable Income
Normally, tax-exempt municipal bond interest is not added to income for tax purposes (although, the interest might be taxable under alternative minimum tax rules). Also note, municipal bonds usually pay lower interest rates as compared to similar bonds which can be taxable.
When you compare taxable investments to tax-free investments, the amount of interest included in income is not the main issue. What is important may be the after-tax yield. For tax-exempt municipal bonds, the after-tax yield is normally comparable to the pre-tax yield. On another hand, a taxable bond's after-tax yield is going to be on the basis of the number of interest remaining after deducting the corresponding number of income tax expense related to the interest earned on a taxable bond. invest in bonds
The after tax return of a taxable bond depends upon a person's effective tax bracket. Generally, tax-free bonds are more appealing to taxpayers in higher brackets; the advantage of excluding interest earned inside their taxable income is greater. On the other hand for taxpayers in lower brackets, the tax benefit is less substantial. Although municipal bond interest is not taxable, the amount of tax-exempt interest is reported on the return. Tax-free interest is used to calculate the amount social security benefits which can be taxable. Tax-free interest also affects the computation of alternative minimum tax and the earned income credit.
Tax-Free Interest is excluded from 3.8% NIIT
Tax-exempt municipal bonds interest can be exempt from the 3.8% net investment income tax (NIIT). The NIIT is compulsory on the investment income of individuals whose adjusted gross (AGI) is in excess of:
· $250,000 for filing status Married Filing Joint and Qualifying Widower,
· $125,000 for filing status Married Filing Separate, and
· $200,000 filing status Single and Head of Household.
Tax Advantaged Accounts
Purchasing municipal bonds in your regular IRA, SEP, or §401(k) is really a no-no. These accounts grow tax free and when withdrawals are created, the amount withdrawn is taxable. Thus, if you desire fixed income obligations in a tax advantaged account consider taxable bonds or similar income securities.
Alternative Minimum Tax Considerations
Interest on municipal bonds is normally not included in income for regular federal income taxes. Interest earned on certain municipal bonds called "private activity bonds" is included in the calculation of alternative minimum tax (AMT). The AMT is a parallel tax system established to make sure that taxpayers pay a minimum number of taxes. The intention of making AMT was to prevent individuals from addressing many tax breaks, for example tax-free interest. The tax breaks are added back in income and cause many people lose tax breaks and pay taxes.
Ramifications of Tax-Free Interest on Taxability of Social Security
A percentage of social security benefits are taxable when other income besides social security benefits surpasses certain amounts. For this reason, the amount of taxable social security benefits adds tax-exempt interest into the amount of other income received besides social security benefits to find out the amount of taxable social security benefits. Consequently, if you get social security benefits, tax-free interest could increase the amount of tax paid on social security benefits.
Ramifications of Tax-Free Interest on the Calculation of Earned Income Tax Credit
When a taxpayer is otherwise qualified to receive the earned income tax credit, the credit is lost completely when the taxpayer has significantly more than $3,400 (2015) of "disqualified income." Disqualified Income generally is investment income like dividends, interest -income, and tax-exempt income. Thus, having municipal bond fascination with excess of $3,400 causes a taxpayer to get rid of the credit. However, an individual qualified for the earned income tax credit is in a diminished tax bracket and an investment in municipal bonds would yield a diminished after tax return as compared to taxable bonds.
A Bond Sale or Redemption
Selling an attachment before maturity or redemption has exactly the same tax consequences as a taxable bond. Gains from sale are taxable. Losses are deducted from other gains; and losses in excess of gains are allowed up to $3,000, the residual losses are carried over to future years.
Selling Bonds Purchased At a Discount
Bonds acquired with "market discount", have special calculations then they are sold. The discount that accrued during the time scale maybe treated as ordinary income.
Mutual Funds
Some investors want professionals to handle a diversified portfolio of municipal bonds, to lessen the default risk on any particular bond issue. There are certain mutual funds that invest in tax-free municipals and manage them.
