What Is a Taxable Municipal Bond?

A taxable municipal bond is a fixed-income security issued by a local government, such as a city, county, or related agency, where the bond income is not exempt from tax. Taxable municipal bonds are generally issued to finance a project or activity that does not provide a major benefit to the public. In such cases, the federal government will not permit a tax-exemption.

Key Takeaways

  • Taxable municipal bonds are fixed-income securities that are issued by local governments. The income from the bond is not exempt from tax.
  • Municipal bonds are generally tax-exempt. 
  • Taxable municipal bonds are typically used to fund projects that don’t directly benefit the general public. 
  • These bonds are popular among institutional investors and mutual funds. 

How a Taxable Municipal Bond Works

A prominent feature of most municipal bonds is that they are tax-exempt. A municipal bond is a bond issued by local and state governments to fund projects for the betterment of the community, such as building schools, highways, and hospitals. A municipality may also issue a bond on behalf of a private company which may be otherwise unable to obtain financing for the project. 

In this case, private activity bonds attract private businesses and the jobs they would bring to the area. An investor who buys a muni bond is lending money to a municipality who promises to pay interest periodically until the bond matures, at which point the principal investment is repaid to the investor. 

In order to encourage investors to purchase municipal bonds, the bonds are set up as exempt from federal taxes and some state taxes, depending on the situation and individual state laws. However, the tax-exempt status of municipal bonds is only granted if the projects funded from the proceeds of the issue provides a significant benefit to the business’s community at large.

While many investors will choose municipal bonds for the tax benefit despite the lower yield, there may be taxable bonds available that offer an after-tax yield that is higher, depending on the individual’s current tax bracket. 

Types of Taxable Municipal Bonds

The majority of taxable municipal bonds are issued to finance the shortfalls of state and local pension funds. Other situations where taxable municipal bonds may be issued include financing local sports facilities, fund infrastructure-related repairs, investor-led housing, or to refinance debt. 

Build America Bonds (BABs) are an example of taxable municipal bonds. BABs were created under the American Recovery and Reinvestment Act (ARRA) of 2009 and, although taxable, have special tax credits and federal subsidies for either the bond issuer or holder. Taxable municipal bonds are popular among institutional investors and mutual funds that cannot take advantage of other tax breaks.

Requirements for Taxable Municipal Bonds

Interest from municipal bonds issued to finance projects with no obvious public benefits is taxable since the federal government will not subsidize the financing of these projects. Since income from such bonds is taxable in the hands of the investor, taxable municipal bonds offer risk-adjusted yields that are comparable to those available from other taxable entities such as corporate bonds and other government agency bonds. The risks and benefits of each option will vary depending on a number of individual factors. 

Some taxable municipal bond issues are exempt from state and, often, local taxes, in which case, investors who reside in the state of issuance are not taxed on their interest earnings at the state level. Thus, the effective yield that they earn on the bond will actually be higher than the stated yield.