If you’re interested in investing in tax-free municipal bonds, you may wonder if they’re really free of taxes. While the investment generally provides tax-free interest on the federal (and possibly state) level, there may be tax consequences. Here’s how the rules work.

Purchasing a bond 

If you buy a tax-exempt bond for its face amount, either on the initial offering or in the market, there are no immediate tax consequences. If you buy such a bond between interest payment dates, you’ll have to pay the seller any interest accrued since the last interest payment date. This amount is treated as a capital investment and is deducted from the next interest payment as a return of capital.

Interest excluded from income 

In general, interest received on a tax-free municipal bond isn’t included in gross income although it may be includible for alternative minimum tax (AMT) purposes. While tax-free interest is attractive, keep in mind that a municipal bond may pay a lower interest rate than an otherwise equivalent taxable investment. The after-tax yield is what counts.

In the case of a tax-free bond, the after-tax yield is generally equal to the pre-tax yield. With a taxable bond, the after-tax yield is based on the amount of interest you have after taking into account the increase in your tax liability on account of annual interest payments. This depends on your effective tax bracket. In general, tax-free bonds are likely to be appealing to taxpayers in higher brackets since they receive a greater benefit from excluding interest from income. For lower-bracket taxpayers, the tax benefit from excluding interest from income may not be enough to make up for a lower interest rate.

Even though municipal bond interest isn’t taxable, it’s shown on a tax return. This is because tax-exempt interest is taken into account when determining the amount of Social Security benefits that are taxable as well as other tax breaks.

Another tax advantage

Tax-exempt bond interest is also exempt from the 3.8% net investment income tax (NIIT). The NIIT is imposed on the investment income of individuals whose adjusted gross income exceeds $250,000 for joint filers, $125,000 for married filing separate filers, and $200,000 for other taxpayers.

Tax-deferred retirement accounts 

It generally doesn’t make sense to hold municipal bonds in your traditional IRA or 401(k) account. The income in these accounts isn’t taxed currently. But once you start taking distributions, the entire amount withdrawn is likely to be taxed. Thus, if you want to invest retirement funds in fixed income obligations, it’s generally advisable to invest in higher-yielding taxable securities.

We can help

These are only some of the tax consequences of investing in municipal bonds. As mentioned, there may be AMT implications. And if you receive Social Security benefits, investing in municipal bonds could increase the amount of tax you must pay with respect to the benefits. Contact us if you need assistance applying the tax rules to your situation or if you have any questions.

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If you have a child or grandchild who’s going to attend college in the future, you’ve probably heard about qualified tuition programs, also known as 529 plans. These plans, named for the Internal Revenue Code section that provides for them, allow prepayment of higher education costs on a tax-favored basis.

There are two types of programs:

1. Prepaid plans, which allow you to buy tuition credits or certificates at present tuition rates, even though the beneficiary (child) won’t be starting college for some time; and
2. Savings plans, which depend on the investment performance of the fund(s) you place your contributions in.

You don’t get a federal income tax deduction for a contribution, but the earnings on the account aren’t taxed while the funds are in the program. (Contributors are eligible for state tax deductions in some states.) You can change the beneficiary or roll over the funds in the program to another plan for the same or a different beneficiary without income tax consequences.

Distributions from the program are tax-free up to the amount of the student’s “qualified higher education expenses.” These include tuition (including up to $10,000 in tuition for an elementary or secondary public, private or religious school), fees, books, supplies and required equipment. Reasonable room and board is also a qualified expense if the student is enrolled at least half time.

Distributions from a 529 plan can also be used to make tax-free payments of principal or interest on a loan to pay qualified higher education expenses of the beneficiary or a sibling of the beneficiary.

What about distributions in excess of qualified expenses? They’re taxed to the beneficiary to the extent that they represent earnings on the account. A 10% penalty tax is also imposed.

Eligible schools include colleges, universities, vocational schools or other postsecondary schools eligible to participate in a student aid program of the U.S. Department of Education. This includes nearly all accredited public, nonprofit and for-profit postsecondary institutions.

However, “qualified higher education expenses” also include expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private or religious school.

A school should be able to tell you whether it qualifies.

The contributions you make to the qualified tuition program are treated as gifts to the student, but the contributions qualify for the gift tax exclusion amount ($16,000 for 2022, adjusted for inflation). If your contributions in a year exceed the exclusion amount, you can elect to take the contributions into account ratably over a five-year period starting with the year of the contributions. Thus, assuming you make no other gifts to that beneficiary, you could contribute up to $80,000 per beneficiary in 2022 without gift tax. (In that case, any additional contributions during the next four years would be subject to gift tax, except to the extent that the exclusion amount increases.) You and your spouse together could contribute $160,000 for 2022 per beneficiary, subject to any contribution limits imposed by the plan.

A distribution from a qualified tuition program isn’t subject to gift tax, but a change in beneficiary or rollover to the account of a new beneficiary may be. Contact us with questions about tax-saving ways to save and pay for college.

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Now that fall is officially here, it’s a good time to start taking steps that may lower your tax bill for this year and next.

One of the first planning steps is to ascertain whether you’ll take the standard deduction or itemize deductions for 2022. Many taxpayers won’t itemize because of the high 2022 standard deduction amounts ($25,900 for joint filers, $12,950 for singles and married couples filing separately and $19,400 for heads of household). Also, many itemized deductions have been reduced or abolished under current law.

If you do itemize, you can deduct medical expenses that exceed 7.5% of adjusted gross income (AGI), state and local taxes up to $10,000, charitable contributions, and mortgage interest on a restricted amount of debt, but these deductions won’t save taxes unless they’re more than your standard deduction.

Bunching, pushing, pulling

Some taxpayers may be able to work around these deduction restrictions by applying a “bunching” strategy to pull or push discretionary medical expenses and charitable contributions into the year where they’ll do some tax good. For example, if you’ll be able to itemize deductions this year but not next, you may want to make two years’ worth of charitable contributions this year.

Here are some other ideas to consider:

• Postpone income until 2023 and accelerate deductions into 2022 if doing so enables you to claim larger tax breaks for 2022 that are phased out over various levels of AGI. These include deductible IRA contributions, child tax credits, education tax credits and student loan interest deductions. Postponing income also is desirable for taxpayers who anticipate being in a lower tax bracket next year due to changed financial circumstances. However, in some cases, it may pay to accelerate income into 2022. For example, that may be the case if you expect to be in a higher tax bracket next year.
• If you’re eligible, consider converting a traditional IRA into a Roth IRA by year end. This is beneficial if your IRA invested in stocks (or mutual funds) that have lost value. Keep in mind that the conversion will increase your income for 2022, possibly reducing tax breaks subject to phaseout at higher AGI levels.
• High-income individuals must be careful of the 3.8% net investment income tax (NIIT) on certain unearned income. The surtax is 3.8% of the lesser of: 1) net investment income (NII), or 2) the excess of modified AGI (MAGI) over a threshold amount. That amount is $250,000 for joint filers or surviving spouses, $125,000 for married individuals filing separately and $200,000 for others. As year-end nears, the approach taken to minimize or eliminate the 3.8% surtax depends on your estimated MAGI and NII for the year. Keep in mind that NII doesn’t include distributions from IRAs or most retirement plans.
• It may be advantageous to arrange with your employer to defer, until early 2023, a bonus that may be coming your way.
• If you’re age 70½ or older by the end of 2022, consider making 2022 charitable donations via qualified charitable distributions from a traditional IRA — especially if you don’t itemize deductions. These distributions are made directly to charities from your IRA and the contribution amount isn’t included in your gross income or deductible on your return.
• Make gifts sheltered by the annual gift tax exclusion before year end. In 2022, the exclusion applies to gifts of up to $16,000 made to each recipient. These transfers may save your family taxes if income-earning property is given to relatives in lower income tax brackets who aren’t subject to the kiddie tax.

These are just some of the year-end steps that may save taxes. Contact us to tailor a plan that will work best for you.

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Here are some of the key tax-related deadlines affecting businesses and other employers during the fourth quarter of 2022. Keep in mind that this list isn’t all-inclusive, so there may be additional deadlines that apply to you. Contact us to ensure you’re meeting all applicable deadlines and to learn more about the filing requirements.

Note: Certain tax-filing and tax-payment deadlines may be postponed for taxpayers who reside in or have businesses in federally declared disaster areas.

Monday, October 3

The last day you can initially set up a SIMPLE IRA plan, provided you (or any predecessor employer) didn’t previously maintain a SIMPLE IRA plan. If you’re a new employer that comes into existence after October 1 of the year, you can establish a SIMPLE IRA plan as soon as administratively feasible after your business comes into existence.

Monday, October 17

• If a calendar-year C corporation that filed an automatic six-month extension:
  • File a 2021 income tax return (Form 1120) and pay any tax, interest and penalties due.
  • Make contributions for 2021 to certain employer-sponsored retirement plans.

Monday, October 31

• Report income tax withholding and FICA taxes for third quarter 2022 (Form 941) and pay any tax due. (See exception below under “November 10.”)

Thursday, November 10

• Report income tax withholding and FICA taxes for third quarter 2022 (Form 941), if you deposited on time (and in full) all of the associated taxes due.

Thursday, December 15

• If a calendar-year C corporation, pay the fourth installment of 2022 estimated income taxes.

Contact us if you’d like more information about the filing requirements and to ensure you’re meeting all applicable deadlines.

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