Municipal bonds are beloved for their tax-free income, but investors snapping up individual issues should be aware of a surprise levy that may be lurking in their midst. Munis are among the assets that have enjoyed a nice boost in yields as the Federal Reserve embarked on its rate-hiking campaign starting in March 2022. The Vanguard Tax-Exempt Bond ETF (VTEB) , for example, has seen about $10.2 billion of inflows in the past year, according to FactSet. Yields on muni bonds are lower than what you’d find in the corporate space – VTEB has a 30-day SEC yield of 3.49%, versus the Vanguard Intermediate-Term Corporate Bond ETF’s (VCIT) 5.53% – but investors like the relative safety of these government issues. Moreover, on a tax-adjusted basis, the muni yield is higher than the stated yield. The tax benefit is nothing to sneeze at, either. High-income investors – especially those in the 32% marginal federal income tax bracket – appreciate that munis offer income that’s exempt from federal levies. Income may also avoid state and local taxation if an investor lives in the same locale where the bond is issued. But there’s a catch: Investors who shop for individual issues may find themselves getting bitten by an unexpected tax if they buy bonds that are too deeply discounted. This is known as the de minimis rule. “The big benefit of buying muni bonds is that they pay interest income that is exempt from federal income taxes, so that can pop up as a surprise,” said Cooper Howard, fixed income strategist at Charles Schwab. Paying for a discount Bond yields and prices move opposite to each other. Indeed, as the Fed hiked rates over the past 18 months or so, prices on fixed income assets have come down and yields have run higher. That means municipal bonds are trading at discounts – which can come with tax ramifications if they’re too cheap versus the bond’s par value, or the amount the issuer will repay the investor at maturity. When the discount is less than 0.25% of the par value, times the number of years remaining until maturity, the discount itself is treated as a capital gain . That means it can be subject to a levy of 0%, 15% or 20%, depending on an investor’s taxable income. If the discount is equal to or greater than 0.25% of par value, multiplied by the number of years until maturity, then it’s taxed as ordinary income . Those rates can run as high as 37%, also based on your taxable income. Investors can pay the tax incrementally each year or they can do so in one shot at maturity. Consider an investor who is purchasing a 10-year municipal bond with a par value of $10,000, trading at $9,750. That $250 difference – the discount – is what’s subject to taxes. “Just be careful of what you buy – it’s not a very sexy answer,” said Tim Steffen, CPA and director of advanced planning, private wealth management, at Baird. “Don’t think, ‘I’m buying this at a huge discount.’ Be aware that it can come with tax consequences.” Contending with the tax If you end up with a bond with a discount that’s treated as ordinary income, you can try to sell it before the discount accrues to minimize the hit. You can also work with your accountant and financial advisor to find ways to soften the blow. Consider that high-income investors are more likely to itemize deductions on their income tax returns – that is, they have write-offs exceeding the 2023 standard deduction of $13,850 for singles or $27,700 if married and filing jointly. One of those strategies includes charitable giving, which can entail a donation of highly appreciated assets, to help minimize your tax bill, Steffen said. Investors also shouldn’t overlook the fact that the muni bond is still providing them with tax-free income in their portfolios. If that’s a priority, the discount and its tax treatment might not be consequential in the grand scheme of things. “You need to look at how much of the return is the discount versus how much of it is the coupon,” Steffen said. “Don’t get too laser-focused on the discount and forget about the coupon, which is tax free.”
