Local governments sell municipal bonds to investors to raise money for public amenities, such as schools, roads, airports and hospitals, or to pay existing debts. U.S. investors who purchase these bonds from their local county or city government can receive a complete break from taxes at all levels of government, including federal, state and local. However, municipal bonds usually offer lower returns than the stock market because of the low risk of a municipality defaulting on its obligations.
In keeping with the Tax Reform Act of 1986, the federal government does not levy an income tax on municipal bonds because such taxes would hinder the ability of state and local governments to borrow money, according to financial services firm Morgan Stanley Smith Barney. This exemption limits tax breaks an investor can receive at the federal level. For example, a person who borrows money to purchase municipal bonds cannot receive an additional tax break by deducting her interest as a business expense on her federal return.
Investors in tax-free municipal bonds do not pay income tax at the state level if they purchase bonds issued by a local government within their state, unless they live in Illinois, Iowa, Kansas, Oklahoma or Wisconsin as of 2011, according to Investing in Bonds. Investors who purchase out-of-state municipal bonds will pay regular income tax rates except in Alaska, Florida, Nevada, New Hampshire, South Dakota, Texas, Tennessee, Washington and Wyoming. These states do not levy an income tax, according to the Internal Revenue Service.
Some counties and cities levy a local income tax that residents pay when they file their state returns. For instance, in Maryland this includes the city of Baltimore and all 23 counties, according to the state comptroller. Investors who live in the municipalities that issued the bond almost always receive a full local tax exemption, but they usually must pay income tax on bonds purchased from other municipalities.
Investors can take a federal deduction for state and local income taxes paid on municipal bond profits on IRS Form 1040, Schedule A. Some municipalities have tax-exempt reciprocity agreements and do not tax municipal bonds from outside their areas. In addition, governments that tax bonds purchased by their residents might offer tax breaks on certain types of bonds to encourage investments in infrastructure, according to Investing in Bonds.
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