What are Taxable Municipal Bonds? Avoid this Mistake + FAQs

Taxable municipal bonds are bonds issued by state and local governments where the interest is subject to federal (and sometimes state) income tax, unlike traditional tax-exempt municipal bonds.

Many people assume all “munis” are tax-free. In fact, roughly 15% (about $600 billion) of the $4 trillion municipal bond market is made up of taxable issues 📊 – a surprise to many investors. These often-overlooked bonds can offer higher yields and unique opportunities, but their tax treatment can make or break your after-tax returns.

This expert guide will demystify taxable municipal bonds in depth, from the types of bonds that fall into this category (like Build America Bonds) to how they’re taxed at federal vs. state levels, who should consider them, and how they compare to tax-exempt munis and corporate bonds.

In this guide, you’ll learn:

• The basics of taxable municipal bonds – what they are, why some munis are taxable, and how they differ from tax-exempt bonds.

• Types of taxable muni bonds (from Build America Bonds to pension obligation bonds) – real examples of when and why governments issue taxable bonds.

• How taxes impact returns – federal vs. state tax treatment of municipal bond interest, including IRS rules, key laws (IRC sections, AMT) and state-by-state nuances (NY, CA, TX, FL, IL).

• Pros, cons, and comparisons – the advantages and disadvantages of taxable municipal bonds, how they stack up against tax-exempt munis and corporate bonds (with side-by-side tables), and scenarios of which is better for whom.

• Key terms, pitfalls, and myths – important terminology explained (so you sound like a pro), common mistakes to avoid when investing, and major misconceptions about taxable municipal bonds debunked.

Taxable Municipal Bonds Explained: When Munis Aren’t Tax-Free

Not all municipal bonds are tax-free. Taxable municipal bonds are issued by cities, states, or other local government entities without the federal tax-exempt interest benefit that muni bonds are famous for.

In other words, if you invest in a taxable muni, the interest you earn will be taxed as ordinary income by the IRS, just like interest from a corporate bond or bank CD. This is in contrast to traditional tax-exempt municipal bonds, whose interest is exempt from federal income tax (and often exempt from state tax for residents of the issuing state).

Why would a municipality issue a taxable bond? There are a few key reasons a muni bond might be taxable rather than tax-exempt:

• Federal law restrictions: The U.S. federal government (through the IRS code) limits the types of projects that qualify for tax-exempt status. Bonds used for purposes that don’t provide broad public benefits or that involve too much private involvement can lose the tax-exempt privilege. In these cases, the municipality might issue the bonds as taxable so they can still raise funds. For example, financing a sports stadium, an investor-owned housing development, or a pension fund shortfall are activities the federal government won’t subsidize via tax breaks​

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  . As a result, bonds for those purposes come with taxable interest.

• Special federal programs: Sometimes Congress deliberately creates taxable municipal bonds programs that offer other incentives. A prime example was the Build America Bonds (BABs) program in 2009–2010, where municipalities issued taxable bonds but received a direct interest subsidy from the federal government. In exchange for taxable status, the U.S. Treasury paid issuers 35% of the interest cost. This program helped local governments borrow cheaply during the Great Recession, even though investors had to pay taxes on the interest.

• Refinancing older debt: Traditionally, municipalities could refinance (refund) their debt with new tax-exempt bonds. However, the Tax Cuts and Jobs Act of 2017 changed the rules, banning tax-exempt advance refundings (refinancing a bond more than 90 days before its call date). Since 2018, any advance refinancing must be done with taxable bonds​.

• This led to a surge in taxable muni issuance as cities took advantage of low interest rates in 2019–2020 to refinance old bonds. In some recent years, taxable issues comprised over 20% of new municipal bond sales – a significant jump.

• Maximizing investor base: By issuing a taxable bond, a municipality can appeal to a broader range of investors. Tax-exempt bonds mainly attract investors in high tax brackets (who benefit most from the tax break). But taxable munis can attract pension funds, endowments, IRAs, and foreign investors who aren’t as concerned with U.S. tax-exempt status.

• These buyers care more about raw yield and credit quality. As a result, some large municipalities opt for taxable deals (even if they could issue tax-exempt) to tap into demand from global or institutional investors that might not typically buy muni bonds. For instance, a city might issue a taxable bond with a structure similar to corporate bonds (like being non-callable or having a “make-whole” call provision) to entice corporate bond buyers.

In essence, taxable municipal bonds exist when the usual tax-free treatment is not available or not chosen. They allow governments to finance projects that don’t qualify for tax exemption or to leverage federal programs and broader investor markets.

While investors pay taxes on the interest, issuers often offer higher interest rates to compensate. This means taxable munis often yield more than their tax-exempt cousins – but the trade-off is you owe taxes on that interest income.

How common are taxable munis? They represent a minority of the muni market but a sizable one. Roughly 10–15% of outstanding municipal bonds are federally taxable, equating to hundreds of billions of dollars​. Since 2008, over $1 trillion of taxable municipal bonds have been issued​.

The sector got a big boost from the Build America Bonds era and continues to grow due to taxable refundings and pension-related bonds. So while most muni bonds you encounter are tax-exempt, don’t be surprised if a bond from a city or state carries taxable interest – it’s more common than many think.

Types of Taxable Municipal Bonds: From Build America to Pension Bonds

Not all taxable munis are the same. Several distinct categories of bonds fall under the “taxable municipal” umbrella. Let’s explore the major types of taxable municipal bonds and why they come into being:

Build America Bonds (BABs) – Taxable Stimulus Bonds 💵

Build America Bonds are perhaps the most famous taxable municipal bonds. They were created under the American Recovery and Reinvestment Act of 2009 as a response to the financial crisis. BABs could be issued in 2009 and 2010 by municipal issuers for almost any public-purpose project (like building roads, schools, infrastructure), but unlike normal munis, their interest is taxable to investors.

Why would issuers opt for this? Because the federal government provided a generous subsidy: for “Direct Pay” BABs, the U.S. Treasury paid the issuer 35% of each interest payment. This subsidy effectively lowered the net interest cost for the municipality.

For example, if a city issued a BAB at a 10% interest rate (to keep numbers simple), the feds would reimburse 3.5%, so the city’s net cost is 6.5%—comparable to a tax-exempt rate—while investors get the full 10% but must pay tax on it. There were also “Tax Credit” BABs where investors received a tax credit instead of the issuer subsidy, but those were less popular.

Key facts about BABs:

• Time-limited program: BABs were only issued in 2009–2010. In that span, municipalities sold $181 billion+ of Build America Bonds. No new BABs have been issued since the program expired, but the bonds issued then often had long maturities (20-30 years) so many are still trading in the market today.

• High quality and big deals: Many BABs came from large, highly rated issuers (states, big cities, universities) and the issues were often sizable. They were designed to attract institutional investors. BABs typically had structures like “make-whole” call provisions (allowing the issuer to refinance by paying a lump sum penalty, like corporates do, instead of the usual 10-year free call common in munis). This made them more familiar to corporate bond buyers.

• Taxable interest: If you hold a Build America Bond, you pay federal tax on the interest (and state tax, unless you’re a resident of the issuing state). The issuer gets the federal subsidy (though note: due to federal budget issues, that subsidy was later cut slightly by sequestration in some years, affecting issuers, not investors).

BABs demonstrated that taxable munis can find a strong investor base when yields are attractive. They effectively opened the municipal market to more global investors. There has even been talk in Congress at times about reviving a similar program because BABs were considered successful in lowering borrowing costs during a tough economic period.

Pension Obligation Bonds (POBs) – Funding Pension Gaps (Taxably)

A Pension Obligation Bond is a bond issued by a state or local government to raise money to fund its pension liabilities (the money owed to retirees). POBs are almost always taxable municipal bonds. Why? Because using debt to shore up a pension fund is not considered a qualified public purpose for tax-exempt financing in the federal tax code. The IRS isn’t going to give a tax break for what is essentially a balance sheet maneuver rather than a new capital project for the public.

How they work: Imagine a city has a big unfunded pension liability. It might issue a taxable bond, take the proceeds and invest them into the pension fund, hoping to earn a return higher than the bond’s interest cost. It’s a form of arbitrage – and it carries risk. If the pension fund’s investments underperform, the city could end up worse off (owing bond interest on top of still underfunded pensions).

Because of that risk, POBs can be controversial. But many governments have used them, especially when interest rates are low. For example, Chicago, Illinois and New Jersey have issued sizable taxable pension bonds. The highest percentage of taxable municipal issuance in recent years has been to fund pension shortfalls​.

These bonds usually come as “taxable GO bonds” (general obligation of the issuer) or certificates of participation, and often in large multi-hundred-million or billion-dollar deals.

Investor considerations: Pension bonds are backed by the issuer (and sometimes specifically by a promise to pay from general funds), but the fact the issuer has pension troubles means investors must consider credit risk. On the upside, because these are taxable, yields tend to be higher than similar tax-exempt GO bonds of the same issuer. If a state issues a tax-exempt GO at 2% and a taxable pension bond GO at 3.5%, an investor in a low tax bracket or an institution might prefer the 3.5% taxable for the extra yield.

POBs highlight a general point: taxable munis often come with unique purposes and sometimes reflect financial stress (like pension underfunding). They can still be high quality (depending on the issuer’s overall strength), but always do your homework on why the bond is being issued.

Private-Activity and Stadium Bonds – When Public Bonds Serve Private Needs

Another class of taxable municipal bonds comes from projects that involve private use or benefit, which run afoul of the tax-exempt rules. The IRS code allows some “private activity bonds” to be tax-exempt (for example, bonds for nonprofit hospitals or affordable housing can be exempt under certain conditions). But for sports stadiums, convention centers, certain industrial development projects, or any deal where a private party is the primary beneficiary, the interest usually cannot be federally tax-free (unless it fits narrow exceptions).

Stadium Bonds: Building a new football or baseball stadium often involves a city or authority issuing bonds. Because a professional sports team (a private business) will heavily use and benefit from the facility, these bonds often do not qualify for tax exemption under federal law (the Tax Reform Act of 1986 heavily curtailed tax-exempt stadium bonds). So, cities either have to issue taxable bonds to finance stadiums or find creative loopholes. Many stadium financings end up taxable for this reason. Investors in such bonds get higher interest to compensate for taxes, and the team or city usually covers that higher interest cost through revenues (like stadium rents, ticket taxes, etc.).

Economic development bonds: Similarly, if a city wants to support a private project (like a hotel, a shopping center, or a privately-owned housing development) with bond financing, it might issue through an economic development authority. If the project doesn’t meet the criteria for tax-exempt private activity bonds, those bonds will be taxable.

Examples: A local development agency might issue a taxable municipal bond to help finance a new privately operated toll road or a mixed-use real estate development. The bond is a municipal security (issued by the agency), but because the proceeds benefit a private venture, interest is taxable. Often these bonds are secured by project revenues or payments from the private company, not the general taxes of the city, so they resemble corporate bonds in risk profile. They’re typically called “taxable industrial development bonds” or similar.

Investor note: These types of taxable munis can range widely in risk. Some might be quasi-government backed (like a city sports authority bond with some tax backing), while others depend entirely on project cash flow (akin to a corporate bond). Always look at the credit structure. They do tend to yield quite a bit more than general government muni bonds (since they lack the tax benefit and may carry more risk).

Advance Refundings (Taxable Refis) – Refinancing Old Debt with Taxable Bonds

Municipal issuers frequently refinance their debt to save on interest costs, similar to how homeowners refinance mortgages. Prior to 2018, an issuer could do an advance refunding with a new tax-exempt bond (paying off an old bond that isn’t callable yet by escrowing funds). But the 2017 tax law (TCJA) put a stop to tax-exempt advance refundings. Now, if a city wants to refinance an old bond ahead of its call date, the new refunding bond must be taxable.

This has created a large category of taxable munis:

• Taxable refunding bonds: These are bonds issued to refinance previously tax-exempt bonds at lower rates. They themselves are taxable since the law no longer allows the new issue to be tax-free. The proceeds usually go into an escrow (often invested in U.S. Treasuries) to pay off the old bonds at their call date.

Why investors care: These taxable refunding bonds are often high-quality (since they are usually backed by the same pledge as the original tax-exempt bond, like a state’s GO credit or a utility revenue pledge). Essentially, you get a high-grade municipal credit but in a taxable format. For instance, in 2020 a lot of AAA/AA-rated state and city bonds were issued as taxable refundings when interest rates plummeted. For investors like insurance companies or funds that don’t benefit from tax exemption, this was a boon – suddenly there was a supply of high-grade taxable muni bonds yielding more than Treasuries.

Characteristics: Taxable advance refunding bonds might be labeled in the issue description, e.g., “City of XYZ Taxable GO Refunding Bonds, Series 2020.” They often have relatively shorter maturities or specific redemption structures aligned with the old bonds. Yields will be higher than the issuer’s tax-exempt yield curve. These issues helped drive taxable muni volume to notable levels (for example, by some accounts, taxable munis were over 25% of municipal bond issuance in 2020, largely due to refundings).

Other Niche Taxable Munis (Tax Credit Bonds and More)

There are a few other less common types of taxable municipal bonds worth mentioning:

• Tax Credit Bonds: In the late 2000s and early 2010s, Congress introduced bonds like Qualified School Construction Bonds (QSCBs), Qualified Zone Academy Bonds (QZABs), and Clean Renewable Energy Bonds (CREBs). These were taxable bonds where instead of tax-exempt interest, the bondholder received a federal tax credit or the issuer got a subsidy. They were used for specific purposes (schools, energy projects). While not large in volume compared to the above types, they are part of the taxable muni landscape. If you encounter one, know that the interest is taxable, but a portion of the benefit came as a tax credit or subsidy by design.

• Municipal Lease revenue bonds that are taxable: Sometimes governments issue lease-backed bonds (where a public agency leases a building and that lease revenue secures the bonds). If the financing doesn’t qualify for tax exemption (perhaps because of some private use in the facility), those lease revenue bonds might be taxable.

• Territory bonds: Bonds from U.S. territories like Puerto Rico, Guam, USVI, etc., have a special tax status: their interest is generally triple tax-exempt (federal, state, local) under Section 103. However, if a territory or possession ever issued a taxable bond (by choice or circumstance), it would fall under taxable munis. (These are rare; most territorial bonds aim for tax-exempt status.)

In summary, taxable municipal bonds come in many flavors, but they all share one thing: interest that is not exempt from federal income tax. Whether it’s because of the project’s nature (private benefit, pension funding), a strategic choice (using a federal program or reaching new investors), or a legal necessity (refinancing rules), the issuer forgoes the tax-exemption and compensates investors with higher interest rates or other incentives.

Next, let’s dive into how exactly these bonds are taxed and what the IRS and state laws say.

Federal Tax Law and Municipal Bonds: IRS Rules, Codes & Court Rulings

At the federal level, the Internal Revenue Service (IRS) treats interest from municipal bonds in one of two ways: exempt or taxable. The default rule (established by Congress in the Internal Revenue Code) is that interest on state and local government bonds is exempt from federal income tax (IRC Section 103), provided certain conditions are met. Taxable municipal bonds are basically those that do not meet the conditions for tax-exemption, or that are specifically issued as taxable by law.

Internal Revenue Code and tax-exempt criteria: Section 103 of the IRC lays out that interest on municipal obligations is excluded from gross income (i.e., tax-free) except for “private activity bonds” that are not qualified and a few other exceptions. The code sections 141 through 150 go into detailed tests that a bond must pass to be tax-exempt – for example, the 10% private use test (no more than 10% of proceeds can benefit private business, typically) and the prohibition on arbitrage (you can’t just invest tax-exempt bond proceeds in higher-yielding securities for profit). If a bond fails these tests, the IRS will deem the interest taxable.

For example, a city issuing bonds and handing the money to a private company (say, to build a factory) would violate the private use test unless it falls under a qualified category with volume cap. Thus, that bond’s interest would be taxable to investors unless it qualifies as an exempt facility bond under allowed categories (airports, affordable housing, etc., which have their own rules). The bottom line: the IRS only allows tax-exemption for municipal bonds that serve broadly public purposes or fit narrow qualified private categories. Do something outside those bounds, and investors must pay tax on the interest.

Key IRS code sections to note:

• IRC §103: General exemption for interest on state/local bonds (and outlines private activity exceptions).

• IRC §141-147: Definitions of private activity bonds and qualified bonds. For instance, §141 defines when a bond is a private activity bond (PAB); §142-147 list types of projects (like airports, docks, sewers, 501(c)(3) nonprofits, etc.) that can still be tax-exempt PABs if conditions are met. If a PAB doesn’t qualify, it’s taxable.

• IRC §149: Miscellaneous rules, including the requirement that muni bonds must be in registered form for interest to be tax-exempt (no bearer bonds; this came up in a famous court case, see below).

• IRC §54A, §54AA, etc.: These were sections for tax credit bonds and Build America Bonds. For instance, §54AA authorized Build America Bonds, stating that BAB interest is taxable but provided the 35% subsidy or tax credit mechanism.

Supreme Court rulings – is tax-exempt interest a right or a privilege? Historically, there was a doctrine of “intergovernmental tax immunity” which suggested the federal government couldn’t tax interest on state obligations (and vice versa). However, this was never absolute. In South Carolina v. Baker (1988), the U.S. Supreme Court held that Congress has the authority to tax interest on state and local bonds; the tax exemption exists because Congress chooses to keep it (through legislation), not because the Constitution requires it. This case upheld a federal law that stripped tax-exemption from bonds not issued in registered form, making it clear that the exemption is a conditional privilege. In short, municipal bond interest is tax-free because Congress wants to encourage local public financing – if Congress changed the law, even traditional muni interest could become taxable (there’s no constitutional guarantee). Investors should remember that while unlikely, the scope of tax-exemption is set by law and can evolve.

Another notable case on the state side is Department of Revenue of Kentucky v. Davis (2008). In that case, the Supreme Court upheld states’ practice of taxing interest on out-of-state municipal bonds while exempting their own. Kentucky residents had argued that it was unfair (and unconstitutional under the Commerce Clause) for Kentucky to tax interest from, say, Illinois munis while not taxing Kentucky muni interest. The Court ruled this differential state tax treatment is allowed – states can give a home-state preference. This affirmed the status quo that most states follow (more on state taxes in the next section).

Tax treatment of taxable vs. tax-exempt interest (investor perspective): If you own a tax-exempt municipal bond, the interest is excluded from your gross income on your federal tax return. You will still receive a Form 1099-INT from the payer reporting how much tax-exempt interest you got (it goes in a special box for tax-exempt interest), and you do report that amount on your 1040 for informational purposes (it doesn’t get taxed, but the IRS keeps track). Tax-exempt interest is also usually not subject to the 3.8% Net Investment Income Tax (NIIT), and it does not count as taxable income for figuring things like the Medicare surtax. (However, note it is included in the calculation for taxability of Social Security benefits and in determining NIIT threshold income – so very large tax-exempt interest can have side effects, but that’s another tangent.)

If you own a taxable municipal bond, the interest is treated just like interest from any corporate bond or bank account:

• It is fully taxable at your ordinary income tax rate at the federal level. You’ll get a standard 1099-INT for interest (in the taxable interest box) and need to include that interest in your taxable income.

• If you’re a high earner, taxable interest is subject to the 3.8% NIIT as part of your investment income.

• There’s no special tax break – it doesn’t matter that it’s a “municipal” bond; the IRS sees it as taxable interest, period.

One nuance: Alternative Minimum Tax (AMT). Some tax-exempt municipal bonds (specifically, certain private activity bonds) generate interest that is exempt from regular tax but counts as an “AMT preference item.” If you are subject to AMT, that interest effectively gets taxed under the AMT system. With taxable municipal bonds, there’s no such complexity – since they’re taxable under the normal tax, you don’t have to do anything special for AMT (their interest is just ordinary income, not a preference item). So in a way, taxable munis are AMT-proof – you don’t worry about AMT separately because you’re already paying regular tax on them.

In summary, at the federal level taxable muni bond interest = fully taxable income, tax-exempt muni interest = excluded by law (with a few exceptions like AMT). The IRS code draws that line based on bond purpose and type. Next, we’ll see how states handle the taxation of muni bond interest, which adds another layer of nuance.

State Tax Treatment: Navigating State and Local Taxes on Muni Bonds

State income taxes add another dimension to municipal bond investing. Even if a bond’s interest is taxable (or tax-exempt) for federal purposes, states can have their own rules. The general patterns are:

• Home state exemption: Most states exempt interest on bonds issued by that state or its local governments from that state’s income tax. For example, if you live in New York, the interest from New York State or New York City municipal bonds is exempt from New York state (and NYC) income tax. This often applies whether the bond is federally tax-exempt or taxable. The exemption typically depends on the issuer, not the federal tax status. So a New York resident holding a taxable municipal bond issued by New York State would pay federal tax but not NY state tax on that interest. This home-state bias is intended to encourage residents to buy their own state’s bonds and help local governments borrow at lower costs.

• Out-of-state bonds are taxable: If you buy a municipal bond issued by a state or city other than your home state, most states will tax that interest even if it’s federally tax-exempt. For instance, a California resident who buys a New Jersey municipal bond will owe California state income tax on the interest. Likewise, a New York resident buying a Texas bond would pay NY tax on the interest (if NY had any tax on interest, which it does, around 10% for top bracket including NYC). The logic is states generally only grant tax-free status to their own bonds.

• States with no income tax: Florida, Texas, Nevada, Washington, Tennessee (on most interest), South Dakota, Wyoming, and Alaska have no personal income tax (or no tax on investment income). If you live in one of these states, you won’t pay any state tax on municipal bond interest, period. Whether the bond is from in-state or out-of-state or taxable or tax-exempt federally doesn’t matter – there’s simply no state tax. So, an investor in Texas can ignore the state tax aspect entirely and focus on federal taxation and yields.

• States with special cases: A few states have unique rules. For example, Indiana taxes interest from out-of-state bonds but also from in-state bonds that are not Indiana muni bonds (like if Indiana residents buy bonds from U.S. territories, which are triple-tax-free federally, Indiana still taxes those – a rare case). Utah similarly taxes interest on bonds from territories. These are quirks, but for mainstream cases the rule stands: in-state munis get a pass, out-of-state get taxed.

Let’s look at some specific high-profile states and their approach:

• New York (and NYC): New York state exempts interest on New York State and local bonds from state income tax. New York City also exempts interest on NYC bonds from the NYC resident income tax. However, interest on bonds from any other state is taxable on your NY return. So, if a NYC resident buys a NYC taxable municipal bond (say a NYC taxable general obligation bond), they’ll pay federal tax on the interest but no NY state or city tax – a nice benefit given NY’s top combined state/city tax rate is ~14%. Conversely, if that NYC resident buys a taxable bond issued by Chicago, they’ll owe NY state/city tax on the interest because it’s out-of-state (on top of federal tax).

• California: California exempts interest on California state and local bonds for CA residents. CA has a high top tax rate (13.3%), so this is significant. If a California investor buys a taxable municipal bond issued by a California city or agency, they pay federal tax but no California income tax on the interest. If they buy any bond from outside CA (taxable or tax-exempt federally), California will tax the interest as regular income. So CA investors heavily favor in-state bonds for tax reasons. (One more nuance: CA does not exempt interest from other states even if those states would reciprocate – reciprocity is not a thing in muni bonds except for territories which are exempt everywhere by federal law).

• Illinois: Illinois taxes interest from out-of-state munis but exempts Illinois bond interest for IL residents. IL has a flat income tax (~4.95%). So an IL resident owning an Illinois taxable pension obligation bond would pay federal tax but no IL state tax on that interest; owning a New York bond would incur IL tax.

• Texas and Florida: As noted, they have no state tax, so residents pay zero state tax on any bond interest. An investor in Florida can buy any state’s munis, taxable or not, and only worry about federal tax. This means the benefit of buying in-state (Florida) bonds for tax reasons is nil in FL, because FL doesn’t tax any interest anyway.

• Municipal Fund States (like DC): A few jurisdictions allow mutual funds that invest only in in-state bonds to be state-tax-free. But individual bond interest typically follows the rules above.

Double and triple tax-exemption: Sometimes you’ll hear terms like “double tax-exempt” or “triple tax-exempt.” Double tax-exempt usually means exempt from both federal and state tax (for an in-state bond). Triple would add local (city) tax exemption too. For example, a bond issued by the City of Los Angeles might be triple tax-exempt for a Los Angeles resident: no federal tax, no California tax, and no LA city tax (actually LA doesn’t have a separate city income tax, but NYC does, Philly does etc.). New York City bonds are triple-tax-exempt for NYC residents (no federal, no NY state, no NYC tax on interest). But if that NYC bond was a taxable municipal bond, then only federal tax would apply, since state and city still exempt it – so it wouldn’t be triple tax-exempt, it would be single-taxed (only by federal).

Taxable municipal bonds and state taxes: If you invest in a taxable muni issued in your state of residence, you likely get the benefit that your state won’t tax that interest (confirm specific state law, but most follow this). This can soften the blow of the taxes. For instance, a California investor buying a taxable California bond at 5% yield would only pay federal tax on that 5% (say 35% bracket = 1.75% in tax), and zero to CA. Meanwhile, if they bought a taxable bond from another state at 5%, they’d pay the same federal 1.75% plus CA tax (13.3% of 5% = 0.665%), total ~2.415% tax, leaving much less net. So in-state taxable munis can be significantly more attractive for residents of high-tax states.

However, if you buy a taxable muni from outside your state, expect to pay both federal and state taxes on the interest, which can really cut into your return if you have a state income tax.

Local taxes: A few cities (New York City, for example) have their own income tax. Typically, they mirror the state in treating muni interest: exempting their own bonds, taxing others. If you live in a city with local income tax, check those rules too.

In summary, state tax treatment often encourages investors to buy in-state bonds. With taxable municipal bonds, that state exemption (if you use it) might be the only tax break you get. If you can’t use it (bond is out-of-state), you could be looking at fully taxable interest at all levels. Always consider where you live and where the bond is issued when evaluating the after-tax yield of a taxable muni. In the next section, we’ll compare taxable munis directly to tax-exempt munis and other bond types to see how they stack up.

Taxable vs. Tax-Exempt vs. Other Bonds: A Side-by-Side Comparison

How do taxable municipal bonds compare to traditional tax-exempt munis, corporate bonds, and U.S. Treasuries? Let’s break down the key differences in terms of issuer, taxation, yield, and investor considerations:

As the table shows, taxable municipal bonds sit somewhere between traditional munis and corporate bonds in many respects. They carry the governmental backing and often high credit quality of munis, but their taxable status means they are priced more like corporates to give a competitive after-tax return.

A few comparisons to highlight:

• Taxation: Tax-exempt munis have the edge for those who need tax-free income, whereas taxable munis must compensate with higher interest. A corporate bond is similar to a taxable muni in tax treatment (both fully taxable), but a taxable muni might have a state tax advantage for in-state investors or a higher credit quality. Treasuries get a unique state tax exemption, which can make them relatively more attractive in high-tax states (but Treasuries still have federal tax, so high-bracket investors often prefer tax-exempt munis if yield is comparable).

• Yield and After-Tax Yield: Suppose a highly rated city can issue a tax-exempt bond at 3% or a taxable bond at 4.5%. A high-tax-bracket investor (say 37% federal) would get 3% tax-free vs 4.5% *0.63 = 2.84% after tax – the tax-exempt wins for them. A moderate bracket investor (24%) gets 4.5% *0.76 = 3.42% after tax – now the taxable is better. So the comparison outcome depends on the investor’s tax situation. We’ll walk through specific scenarios in the next section.

• Risk and default rates: Municipal bonds (taxable or not) have historically very low default rates especially in investment-grade. Moody’s and S&P studies have shown that over decades, investment-grade munis default far less frequently than investment-grade corporates. For example, one study found 10-year cumulative default rates on A-rated munis were around 0.1% versus ~2% for A-rated corporates. That’s a big reason institutions have grown interested in taxable munis – you might get a bond rated AA (e.g. a state general obligation) yielding similar to a corporate bond rated BBB, yet the default risk is arguably lower for the state. In fact, according to New York Life Investments, about 77% of taxable municipal bonds carry a rating of AA or higher, compared to only about 10% of investment-grade global corporate bonds that are AA or above. This highlights the high quality of many taxable munis.

• Liquidity: One downside for taxable munis is that, while the market is growing, it’s still smaller and less traded than the corporate bond market. A corporate bond from Apple or AT&T might trade many times a day; a taxable muni from a mid-sized city might only trade occasionally. However, certain taxable muni segments (like BABs or large state issues) have improved liquidity and even have ETFs and mutual funds specializing in them, which helps.

Next, let’s consider the pros and cons of taxable municipal bonds specifically, and then see some concrete scenarios of which investors benefit most from them.

Pros and Cons of Taxable Municipal Bonds

Like any investment, taxable munis come with advantages and disadvantages. Here’s a quick comparison:

Overall, taxable municipal bonds offer an attractive middle ground: the credit safety of government borrowers, but with yields boosted into taxable bond territory. They can be very advantageous for certain strategies and investors, but they’re not for everyone. Let’s explore who might want to invest in taxable munis and look at some scenarios comparing outcomes.

Who Should Invest in Taxable Municipal Bonds? Investor Profiles & Scenarios

Taxable munis shine in some situations and lag in others. The decision often comes down to your tax bracket, location, and account type. Here are a few investor profiles and scenarios where choosing a taxable municipal bond (versus a tax-exempt muni) makes sense – and where it might not.

To make this concrete, we’ll compare hypothetical scenarios:

Scenario 1: High Tax Bracket in California – Taxable vs Tax-Exempt

Investor: Alice lives in California, with a high income (37% federal tax bracket, and California’s 13.3% state tax). She’s looking at bonds for her taxable brokerage account. She has two choices from California issuers:

• Option A: A California Taxable Municipal Bond yielding 5.0%. (It’s a taxable pension obligation bond issued by a CA city.) Because it’s a CA bond, her state will not tax the interest, but the IRS will.

• Option B: A California Tax-Exempt Municipal Bond (in-state) yielding 3.5%. (A general obligation bond for school construction, federally tax-exempt and also CA tax-exempt since she’s in-state.)

How do the after-tax returns compare?

Result: Option B yields 3.5% to Alice after all taxes, while Option A yields about 3.15% after federal tax. Even though the taxable bond had a much higher coupon (5% vs 3.5%), Alice’s high tax rates erode its advantage. For her, the tax-exempt bond provides a higher after-tax income.

In a high-tax bracket and high-tax state, tax-exempt munis often win unless the taxable muni’s yield is dramatically higher. For Alice, a taxable muni would need to yield above ~5.6% to net more than 3.5% (because 5.6% * (1 – 0.37) ≈ 3.53%). Those kinds of yields might only come with significantly more credit risk. So Alice likely sticks mostly to tax-exempt California munis for her taxable account.

Scenario 2: Moderate Bracket in Texas – Taxable vs Tax-Exempt

Investor: Bob lives in Texas (0% state income tax) and is in the 24% federal tax bracket. He’s considering an investment in municipal bonds for extra income. Since Texas has no state tax, he’s open to bonds from anywhere. His choices:

• Option A: A Taxable Municipal Bond from another state (say a high-grade taxable issue from Illinois) yielding 4.0%.

• Option B: A Tax-Exempt Municipal Bond (could be from any state since TX has no preference) yielding 3.0%.

Texas won’t tax either, so only federal tax matters for Bob on the taxable option.

Result: Option A nets about 3.04% after Bob’s federal tax, slightly above the 3.0% from Option B. In Bob’s case, the taxable municipal bond comes out just ahead. If the taxable bond had an even higher yield or if Bob were in an even lower bracket, the advantage would be bigger.

Because Bob doesn’t pay state tax, he doesn’t need to favor Texas-issued bonds; he can shop nationally for the best yields. A 4% taxable yield is attractive relative to a 3% tax-free yield at his bracket. Bob might also consider corporate bonds or other taxable fixed-income, but if he values the high credit quality of munis, a taxable muni gives him that without sacrificing yield.

This scenario shows that in a no-tax state or lower bracket, taxable munis can be quite competitive and often better on an after-tax basis than tax-exempt munis.

Scenario 3: Using a Tax-Advantaged Account (IRA) – Maximizing Yield

Investor: Carol has a traditional IRA and wants to allocate part of it to bonds. She doesn’t care about current income (it’s all tax-deferred in the IRA). She just wants the best total return and safety combo. She’s looking at munis because of their safety, but inside an IRA, the tax status doesn’t matter to her yield – all interest will eventually be taxed as ordinary income when withdrawn from the traditional IRA, and in a Roth IRA, it’s never taxed.

Her choices for the IRA:

• Option A: Taxable municipal bond yielding 4.5% (say, a high-quality taxable refunding bond).

• Option B: Tax-exempt municipal bond yielding 3.2% (similar maturity and credit rating).

In an IRA, both Option A and B effectively yield their full coupon to the account (no immediate taxes due). The tax-exempt nature of B doesn’t provide any extra benefit inside the IRA (the IRS isn’t taxing the IRA’s interest regardless).

So:

Result: Option A clearly delivers more yield for Carol’s retirement account. She gets the benefit of the higher interest rate without any tax drag, because the IRA defers taxes. If this were a Roth IRA, it’s even more stark – she’d get 4.5% completely tax-free in the end versus 3.2% (the tax-exempt status in a Roth is irrelevant because all Roth earnings are untaxed).

Thus, taxable municipal bonds are excellent candidates for IRAs or 401(k)s. Investors often avoid putting tax-exempt munis in an IRA since you lose the tax benefit but still accept the lower yield; it’s generally inefficient. Carol wisely goes with taxable munis for her IRA if she wants muni exposure.

Other Notable Use Cases:

• Foreign investors: Non-U.S. investors don’t typically get the benefit of U.S. tax-exemption (and in many cases, U.S. tax-exempt interest isn’t attractive to them because they might face withholding or their own country’s taxes). However, interest on U.S. bonds paid to foreigners can often be exempt from U.S. withholding under the “portfolio interest” rule, even if it’s a taxable bond. This means a foreign investor might buy a taxable muni and effectively not owe U.S. tax on the interest (though they might have to pay tax at home). They would ignore tax-exempt munis because those usually don’t qualify as “portfolio interest” (and some tax-exempt bonds can’t be sold to non-U.S. persons easily due to tax law complications). Thus, a high-quality taxable muni with a nice yield could be very attractive to a foreign institution relative to other global bonds. This was indeed one reason the BAB program was successful – it brought foreign buyers into muni finance.

• Institutional investors (pension funds, endowments): These entities are often tax-exempt themselves or have no tax liability. A pension fund doesn’t care if interest is taxable or not, since it pays no tax. So it will simply seek the best risk-adjusted return. Taxable munis allow pensions and endowments to invest in the muni sector (which they normally avoid because tax-exempt yields are too low for them). For example, a pension fund might love a AA-rated taxable muni yielding 4% instead of a AA corporate yielding 3.5%. The taxable muni broadens their options. This institutional demand in turn supports the taxable muni market.

• Investors avoiding AMT: If someone is subject to the Alternative Minimum Tax, certain “AMT muni bonds” (private activity bonds) lose some appeal because their interest isn’t exempt from the AMT. A taxable muni doesn’t have an AMT complication – it’s just taxed in regular income (and included in AMT income but you’d be paying tax on it anyway). Sometimes very high income folks who get hit by AMT prefer to avoid private activity munis; they might consider a high-quality taxable muni instead if the yields line up, rather than buying an AMT-subject “tax-exempt” bond. (Though with the recent tax law, fewer people pay AMT now due to higher exemptions.)

In conclusion, taxable municipal bonds make sense for:

• Investors in lower tax brackets who can get a better net yield from the higher coupon.

• Investors in no-tax states who don’t need to worry about state taxes on out-of-state bonds.

• Any investor using tax-deferred or tax-free accounts (IRAs, 401ks, Roths) for their bond allocation.

• Institutions or foreigners who don’t benefit from U.S. tax-exemption.

• Situations where the taxable muni’s yield significantly outpaces a comparable tax-exempt and compensates for the taxes.

On the other hand, tax-exempt muni bonds are usually better for:

• High tax bracket individuals in high-tax states investing in taxable accounts (they crave the tax breaks).

• Those who want tax-free income streams (retirees in top brackets often build portfolios of tax-free munis).

• If the yield gap between taxable and tax-exempt is small – then the tax-exempt likely wins for most taxpayers.

Next, we’ll clarify some key terminology that’s been used, then address pitfalls to avoid and misconceptions about taxable municipal bonds.

Key Terminology in Municipal Bond Taxation

To navigate discussions of taxable vs. tax-exempt bonds, it helps to understand these key terms and concepts:

• Municipal Bond (Muni): A debt security issued by a state, city, county, or other local government or public authority. Munis finance public projects like schools, highways, water systems, etc. They come with interest payments (coupons) and return principal at maturity. Munis can be tax-exempt or taxable at the federal level.

• Tax-Exempt Bond: A municipal bond whose interest is exempt from federal income tax (and possibly state/local tax if the investor resides in the issuing state). These are the traditional munis. For example, a New York City tax-exempt bond pays interest that is not taxed by the IRS (and if you live in NY, not by the state or city either). The federal exemption is granted if the bond meets IRS criteria for public purpose.

• Taxable Municipal Bond: A muni bond whose interest is taxable at the federal level (investors must pay income tax on the interest). These bonds do not qualify for the federal tax exemption usually because the use of funds is outside permitted public purposes or because they’re part of a taxable program like Build America Bonds. They often still carry state tax exemptions for in-state buyers. Example: A Build America Bond from California – interest is taxed by IRS, but a CA resident wouldn’t pay CA tax on it.

• General Obligation (GO) Bond: A municipal bond backed by the full faith and credit of the issuing government. GO bonds are repaid through general taxation or other resources of the issuer. They tend to be very secure (since the issuer can use any legal means, like raising taxes, to pay debt service). GO bonds can be tax-exempt or taxable. E.g., a GO bond for a city park (likely tax-exempt), or a GO bond issued to refund debt in a taxable deal.

• Revenue Bond: A muni bond backed by specific revenues from a project or source (not by the issuer’s general tax power). Examples: water utility bonds paid from water fees, toll road bonds paid from tolls. These can also be tax-exempt or taxable depending on the project. Some private-activity bonds are revenue bonds (e.g., an airport bond repaid by airline fees).

• Private Activity Bond (PAB): A municipal bond where the proceeds primarily benefit a private entity or where repayment comes from a private party. The IRS sets tests for what counts as a PAB (e.g., more than 10% of proceeds used by a private business). Qualified PABs (for things like airports, affordable housing, non-profit hospitals, etc.) can still be tax-exempt. Non-qualified PABs are taxable – they’re essentially taxable munis. Additionally, even qualified PABs that are tax-exempt have their interest counted as an AMT preference (unless issued in 2009-2010 when AMT on them was temporarily waived).

• Build America Bond (BAB): A type of taxable municipal bond created in 2009-2010. BABs offered issuers a federal subsidy (35% of interest) or gave bondholders a tax credit. They allowed municipalities to borrow at taxable rates while effectively lowering cost through the subsidy. BABs were part of the stimulus (ARRA) and are no longer issued, but outstanding BABs will be around until they mature (some until 2039-2040). All interest from BABs is taxable income to investors.

• Pension Obligation Bond (POB): A usually taxable muni bond issued to fund pension liabilities. The issuer borrows money (via the bond) and injects it into a pension fund. These are taxable because they don’t fund new capital projects. They are essentially a debt restructuring tool for governments. POBs are backed by the issuer’s promise to repay (often a GO pledge). They carry the risk that the pension investment might not perform as hoped. Notable example: Detroit issued POBs (technically certificates) before its bankruptcy, which later got restructured – illustrating risk.

• Advance Refunding (Pre-Refunding): Refinancing an existing bond by issuing a new bond and escrowing the proceeds until the old bond can be called or matures. If done more than 90 days before the old bond’s call date, it’s an advance refunding. Until 2017, advance refundings could be done with tax-exempt bonds (one time per issue). Now, any advance refunding must use a taxable bond. When you see “Pre-refunded to [date]” in muni listings, it means an advance refunding occurred. Those refunding bonds might be taxable. “Refunding” without advance (within 90 days of call) can still be tax-exempt.

• Make-Whole Call: A type of call provision often seen in taxable bonds (corporates and taxable munis) where the issuer can redeem the bond before maturity by paying a price that equals the present value of remaining payments (essentially a penalty to make the investor “whole”). This contrasts with the typical 10-year par call on tax-exempt munis (where after ~10 years the issuer can call the bonds at par with no penalty). Taxable munis, especially those tailored to institutional buyers, often have make-whole calls or long no-call periods, aligning with corporate bond market norms.

• Tax-Equivalent Yield (TEY): The pre-tax yield a taxable bond would need to equal a tax-exempt bond’s yield after taxes. Investors compute this to compare munis with taxable alternatives. Formula: TEY = (Tax-Free Yield) / (1 – Tax Rate). For example, if a muni yields 3% tax-free and an investor’s combined tax rate is 40%, the TEY = 3%/(1-0.40) = 5%. That means a taxable bond would need to yield 5% to match the muni’s 3% after tax. If the taxable bond yields more than 5%, it’s better for that investor; if less, the muni is better. This calculation is crucial when assessing taxable vs tax-exempt options.

• Alternative Minimum Tax (AMT): A parallel tax system designed to ensure high-income folks pay a minimum tax. Certain tax-exempt muni interest (from private activity bonds) is included in AMT income. So if you’re subject to AMT, that interest isn’t really tax-free – you pay AMT on it. Many muni funds label themselves “AMT-free” meaning they avoid those bonds. Taxable muni interest doesn’t get special treatment under AMT – it’s just taxed normally (and counted in AMT income like any other income). After 2017, fewer individuals hit AMT due to changes, but it still matters to some.

Now that we have the terminology down, let’s cover some common pitfalls and what to avoid when dealing with taxable municipal bonds.

What to Avoid When Investing in Taxable Municipal Bonds

Investing in taxable munis can be rewarding, but watch out for these pitfalls and mistakes:

• ❌ Don’t compare yields blindly: Avoid treating a taxable bond’s interest rate at face value against a tax-exempt bond. Always consider after-tax yield. A 5% taxable yield isn’t automatically better than a 3% tax-free yield – it depends on your tax situation. Calculate the tax-equivalent yield for your bracket or the after-tax yield to make a fair comparison. Ignoring taxes can lead you to pick what looks higher but actually nets you less income.

• ❌ Don’t ignore state taxes: If you live in a state with income tax, avoid buying out-of-state taxable munis without accounting for that extra tax hit. For example, a New Yorker buying a taxable Illinois bond will owe NY taxes on the interest – perhaps reducing the net yield significantly. Whenever you consider a taxable muni, check if it’s from your state. If not, factor in your state tax rate on interest. It might still be worth it, but sometimes an in-state bond with slightly lower coupon could net more after taxes by dodging state tax.

• ❌ Avoid putting tax-exempt munis in tax-deferred accounts: This is a general bond investing pitfall – placing a tax-free investment inside an IRA or 401k. You “waste” the municipal bond’s tax exemption because the account is already tax-sheltered. Instead, in those accounts, use taxable bonds (like taxable munis) to maximize yield. Conversely, in your taxable account, you might favor tax-exempt munis if you’re in a high bracket. In short, align the bond type with the right account: taxable bonds in IRA/401k, tax-exempt bonds in taxable accounts for high-tax investors.

• ❌ Don’t assume “municipal” means risk-free: While munis have generally lower default rates, avoid complacency with credit risk. A taxable muni could be funding a project or a government with known fiscal stress (remember, some taxable issues are for pension debts or private projects). Research the issuer – look at credit ratings, financial health, and the purpose of the bond. If a bond offers an unusually high yield, ask why: it could be because the issuer is struggling (e.g., a city facing budget deficits issuing taxable bonds might be riskier). High yield in munis, like any market, usually means higher risk.

• ❌ Don’t forget liquidity considerations: If you’re investing a large sum or think you might need to sell before maturity, avoid niche, small issuance bonds that could be hard to trade. Some taxable munis might be less liquid than others. For instance, a one-off taxable bond from a small town might not have many buyers in the secondary market. You might face a big bid-ask spread or price impact when selling. To avoid this, either plan to hold to maturity or choose more widely held issues (e.g., large state bonds, or use a taxable muni mutual fund/ETF for better liquidity through the fund).

• ❌ Avoid overpaying (check market yields): Because taxable munis are fewer, sometimes pricing can be less transparent. Always check a benchmark or get a second quote. For example, compare the yield on a taxable muni you’re eyeing with yields on corporate bonds of similar maturity/rating or Treasury yields plus a spread. If something seems off (too low yield for the risk), be cautious. Use the MSRB’s EMMA website or broker quotes to verify recent trades on the bond.

• ❌ Don’t neglect diversification: It’s easy to load up on munis from your state (for tax reasons), but that can concentrate risk in one region. With taxable munis, you might venture out-of-state more (since taxes are less of an obstacle, especially in IRAs or if yields are good). Ensure you diversify across issuers, regions, and sectors. For example, if you buy multiple taxable munis, maybe choose one from a state, one a university (some big universities issue taxable bonds), one a revenue project, etc., to spread risk.

By avoiding these pitfalls, you can make more informed, savvy decisions with taxable municipal bonds and integrate them properly into your portfolio.

Common Misconceptions About Taxable Municipal Bonds

There are several myths or misunderstandings about taxable munis. Let’s clear those up:

• Misconception: “All municipal bonds are tax-free.”
  Reality: Not true – many municipal bonds are fully taxable. While most muni bonds are issued to be tax-exempt, a significant portion (about 15%) are taxable because of how they’re used or structured. Always check the bond’s description; if it says “Taxable” in the title or the official statement, the interest will be subject to tax. Don’t assume “municipal” automatically equals “tax-exempt income.”

• Misconception: “Taxable munis are only issued by troubled governments or unusual cases.”
  Reality: Taxable munis are issued by a wide range of entities, including very creditworthy ones. It’s not just cash-strapped cities. For example, Harvard University (through a conduit) has issued taxable municipal bonds; so have states like California and New York for certain purposes. Build America Bonds were issued by many strong municipalities. So while some taxable munis (like pension bonds) might signal financial stress, many are simply using taxable financing for specific reasons (law changes, federal subsidy programs, etc.). High quality issuers exist in the taxable muni space – it’s not all risky stuff.

• Misconception: “If the bond is taxable, I’ll owe tax on the principal when repaid.”
  Reality: The taxable vs tax-exempt issue applies to the interest income, not the principal. When your bond principal is returned at maturity, that’s just returning your capital (not a taxable event, unless you bought the bond at a discount or premium, which has its own tax rules for market discount or amortization – but that’s a nuance beyond just being a muni). The main point is your interest payments are taxed with a taxable muni, but the principal repayment is not considered income (aside from those specific OID/discount rules that also apply to tax-exempt bonds similarly).

• Misconception: “Taxable munis always have higher yields than tax-exempt munis.”
  Reality: Generally true, but not always in every circumstance. Taxable munis should offer higher yields to entice investors, but occasionally weird market conditions can invert this. For instance, in a market panic, traditional muni yields might spike (tax-exempt yields have at times exceeded Treasury yields, like in early 2020) while certain taxable munis didn’t move as much. Also, within the muni yield curve, a taxable muni from an extremely strong issuer might yield less than a tax-exempt from a much weaker issuer. But as a broad rule, comparing similar credit and maturity, yes taxable will yield more. Just be aware that “higher yield” is before taxes – after-tax, it might or might not be higher for you.

• Misconception: “Interest from a taxable muni is taxed at a higher rate than other interest.”
  Reality: No, it’s taxed the same as any other interest income at ordinary income tax rates. There’s no special surcharge on muni interest just because it’s a muni. (It’s not like qualified dividends or capital gains with special lower rates – interest is interest.) The confusion might come from tax-exempt vs taxable, but once it’s taxable, the interest goes into your tax return like, say, bank interest would. One caveat: if you buy a taxable muni at a deep discount, the IRS may treat the accretion as ordinary income (market discount rule) – but that’s an advanced topic that applies to all bonds, not just munis.

• Misconception: “Municipal bonds can’t default, especially GOs.”
  Reality: While munis, especially GOs, default far less often than corporates, default is still possible. Examples: Detroit’s default (bankruptcy) affected some taxable pension certificates, Puerto Rico (a US territory, but municipal for tax purposes) defaulted on various bonds, some of which were taxable, and Stockton, CA had taxable pension bonds that took a hit in bankruptcy. Always consider the credit rating and essentiality of the project. Don’t let the “municipal” label lull you into ignoring risk – assess each bond on its merits.

• Misconception: “Taxable muni interest might be exempt from state tax even if I don’t live in the issuing state.”
  Reality: Almost never – state tax exemption for munis typically applies only if you are a resident of the state of issuance. If you live elsewhere, that state’s interest is usually taxable to you. There are rare mutual exemptions (some states had pacts historically, and interest on territory bonds is exempt everywhere federally), but as a rule, assume out-of-state muni = taxable by your state, and that doesn’t change just because it’s a muni. So a New Yorker cannot escape NY taxes by buying a California taxable muni; they’ll pay NY tax on it just as they would on a corporate bond.

• Misconception: “I should only buy taxable munis if I don’t pay taxes (e.g., in an IRA or if my income is low).”
  Reality: Taxable munis can also make sense for moderate tax brackets or in taxable accounts if the yields are compelling. It’s not an all-or-nothing. For example, an investor in the 24% bracket might find a mix of taxable and tax-exempt munis provides the best overall income – perhaps they fill their state’s exemption bucket with in-state tax-exempts but then buy some out-of-state taxable munis to diversify and pick up extra yield. It’s about the relative after-tax return. Even high bracket investors might sometimes buy a taxable muni if it’s a unique opportunity (say a rare AAA taxable muni yielding unusually high).

Understanding these realities ensures you approach taxable municipal bonds with clear eyes. Now, with the myths dispelled, you’re equipped to consider how taxable munis fit into your financial strategy or advice to clients.

FAQ: Taxable Municipal Bonds

Q: Are taxable municipal bonds exempt from federal tax?
A: No. Interest from taxable municipal bonds is subject to federal income tax, just like interest from corporate bonds. Only qualifying tax-exempt municipal bonds offer federal tax-free interest.

Q: Do I have to pay state tax on taxable municipal bond interest?
A: Yes, usually. Most states tax interest from municipal bonds unless the bond is issued by your home state (in which case many states exempt it). Out-of-state muni interest is generally taxable.

Q: Can I hold taxable municipal bonds in an IRA or 401(k)?
A: Yes. Taxable munis can be held in retirement accounts, and it’s often smart to do so. In an IRA/401k, you won’t pay taxes on the interest each year, so you effectively get the full yield.

Q: Are Build America Bonds taxable?
A: Yes. Build America Bonds (BABs) are taxable municipal bonds. Investors pay federal tax on the interest. BABs provided issuers a federal subsidy, but from the investor’s perspective the interest was fully taxable.

Q: Do taxable municipal bonds have higher yields than tax-exempt ones?
A: Yes, typically. Taxable munis usually offer higher interest rates to compensate investors for the taxes they’ll owe. The higher coupon is meant to make their after-tax yield competitive with tax-free bonds.

Q: Is interest from municipal bonds ever subject to the AMT (Alternative Minimum Tax)?
A: No, not for taxable munis – they’re taxed normally. (For tax-exempt munis, some private activity bond interest can be taxable under AMT. But if a muni is fully taxable already, AMT doesn’t separately apply.)

Q: Do I still get a 1099-INT for municipal bond interest?
A: Yes. You receive a 1099-INT for municipal bond interest each year. Tax-exempt interest is reported in a separate box on the form (for your info), while taxable muni interest is included in the taxable interest box.

Q: Are taxable municipal bonds similar to corporate bonds?
A: Yes, in some ways. Both are fully taxable and often have similar structures (fixed interest, ratings). However, taxable munis are issued by governments and often carry higher credit quality and lower default risk than comparably yielding corporate bonds.

Q: If I live in a no-income-tax state, do I get any benefit from muni bonds?
A: No state tax means you treat munis like any other bond. Tax-exempt munis give you federal tax-free income, but you had no state tax anyway. Taxable munis in a no-tax state only face federal tax, same as everywhere.

Q: Should high-income investors avoid taxable municipal bonds?
A: Yes, generally. High earners often prefer tax-exempt bonds because a lot of a taxable bond’s interest would be lost to taxes. Taxable munis usually make more sense for lower brackets or in tax-sheltered accounts.