As tax season revs up, investors might be on the hook for reporting – and paying – obligations on their tax-free municipal bonds. Investors are likely gathering the documents they need to file their 2024 tax returns, which are due on April 15. It was a big year for income-generating investments , even as the Federal Reserve trimmed interest rates three times. That means investors are finding themselves on the hook for taxes on interest income as their certificates of deposit, money market funds and high-yield savings accounts offered annual percentage yields exceeding 4%. Municipal bond investors aren’t necessarily spared from tax-season hurdles even as the income from these issues is generally free of federal income taxes (and state taxes if the investor resides in the issuing state). When the Fed was on its rate-hiking cycle in 2022 and 2023, bond prices – including munis – tumbled. Bond prices and yields move in opposite directions. Investors who stepped in to buy up the cheap muni issues got a good deal at the time, but they could be subject to reporting requirements and tax payments each year. “One of the rules with municipal bond discounts is that you have to pick up that spread in income every year, and it can be taxable even if it’s coming from a tax-exempt bond,” said Tim Steffen, certified public accountant and director of advanced planning, private wealth management at Baird. “This isn’t an issue if you’re in a bond fund or a bond ETF, but if you buy individual bonds, you have to be aware of these things.” The de minimis rule When investors buy municipal bonds at a discount to their par value – the amount that the issuer will repay at maturity – tax consequences may arise. If this discount is less than 0.25% of the par value, multiplied by the number of years to maturity, then the discount is taxed like a capital gain . That means it’s subject to rates of 0%, 15% or 20%, depending on the taxable income of the investor. However, if the discount is equal to or greater than 0.25% of par value, times the number of years to maturity, then it is treated like ordinary income . Those rates can be as high as 37%. Consider an investor who buys a 10-year municipal bond with a par value of $10,000, but it’s trading at $9,500. The $500 discount is what is taxable. Most investors opt to pay the tax incrementally each year, but some may do it at maturity, according to Cooper Howard, fixed income strategist at the Schwab Center for Financial Research. Investors should work with their tax professional to find out what works best for them. “If it’s below par, that raises kind of a yellow flag of ‘I gotta look at this a little further,'” Howard said. Other tax hiccups for munis Municipal bonds can also present other tax surprises for investors. For starters, retirees will find that their municipal bond income is counted toward their modified adjusted gross income – the calculation that’s used to determine how much they pay in monthly premiums for Medicare Part B and prescription coverage. In 2025, individuals who file tax returns with modified adjusted gross income that’s $106,000 or less ($212,000 or less for joint filers) will have to pay monthly Part B premiums of $185. Those with income exceeding those income thresholds will have to pay more, with the highest bracket of taxpayers with income exceeding $500,000 (or $750,000 for joint filers) on the hook for Part B premiums of $628.90 per month. Investors who snap up taxable municipal bonds will also find themselves on the hook for levies. Howard estimates that these issues account for about 10% of muni bond market. They generally offer higher yields to compensate for the fact that their interest income is taxable on the state and federal levels. “That detail is listed in the offering statement, and it should be upfront when the individual buys the bond,” Howard said, noting that taxable munis may make sense for investors in low tax brackets and for those who want to hold munis in tax-advantaged accounts like an individual retirement account. “You can get a muni that’s high credit quality, pays higher interest than comparable bonds, and you’re sheltered from the income tax because it’s in an IRA,” he said.
Watch out for this unexpected tax hit from your municipal bonds