Muni Bonds and Taxes.

[rattlenap]

Help me to understand Muni Bonds and taxes. So when you put money into say a state specific CA Tax Exempt Muni Bond fund via a taxable account.

You pay neither Federal nor State taxes on the income, correct?

But when you withdraw the money from the fund you will have to pay capital gains taxes either ST or LT, right?

Please educate me here.

[bloom2708]

You are correct.

The value of bond funds moves in a pretty narrow window, so you should expect to not have a big gain or loss. If interest rates start rising fast, you can get a 10-20% change in value.

Stick with the intermediate term CA or non state specific tax-exempt funds to keep the duration at a reasonable level.

[MP123]

Correct assuming you live in California and are buying a CA bond fund.

I don't think any states tax interest from their own muni bonds but many do tax interest from other states bonds which is why they have state specific funds. Muni bond interest isn't taxed at a Federal level either.

If you live in a state without income tax this opens even more possibilities since you won't be taxed on muni bond interest from any state.

[rattlenap]

So you will have to pay either long-term or short-term capital gains if you withdraw the money then?

[Avo]

Yes, if you have gains (you might have a loss).

[Good Listener]

Also I need to inform you that the muni funds have distributed both LT and ST capital gains distributions for the last several years and although I don't understand why will continue to do so if rates rise even slowly. Already for example the NJ long term fund has 4 cents per share in realized gains.

[rkhusky]

So you will have to pay either long-term or short-term capital gains if you withdraw the money then?

The gains/losses should be relatively small compared to stock cap gains.

[Geologist]

Also I need to inform you that the muni funds have distributed both LT and ST capital gains distributions for the last several years and although I don't understand why will continue to do so if rates rise even slowly. Already for example the NJ long term fund has 4 cents per share in realized gains.

This is imprecise. The Vanguard (national) Intermediate Tax-Exempt Fund hasn’t distributed any capital gains since 2002 and so far this year has a realized capital loss. The Limited-Term Tax-Exempt and Short-Term Tax-Exempt Funds have distributed no capital gains in more than five years. The national Long-Term fund has distributed some capital gains in the last three years. I can’t speak to state-specific funds, although they are mostly long-term.

[Artsdoctor]

Help me to understand Muni Bonds and taxes. So when you put money into say a state specific CA Tax Exempt Muni Bond fund via a taxable account.

You pay neither Federal nor State taxes on the income, correct?

But when you withdraw the money from the fund you will have to pay capital gains taxes either ST or LT, right?

Please educate me here.

There are several moving pieces here.

Since you mentioned California, we can use that as an example. However, there are some states that WILL tax some of their own state's municipal bonds (for example, IL) so make sure you know your state's tax laws.

Your monthly dividends will be exempt from both federal and state income tax. However, you'll need to see if the fund's dividend are exempt from the AMT. Some funds will have a portion of the dividends subject to the AMT so you'll need to do your homework.

When you ultimately sell shares of your muni bond fund, you will have to see if those shares have been sold at a gain or loss and report it accordingly. You'll report the gains (or losses) on both federal and state returns.

The fund MAY report out a capital gains distribution, much like any equity fund. At Vanguard, this amount is usually small although you should take a look at the website to see previous distributions. Long-term capital gain distributions can be offset against any losses generated by a sale; short-term capital gain distributions cannot and must be counted as taxable income.

California will tax municipal bond income from other states (although not from Puerto Rico).

Lastly, there is a difference when considering taxation of individual tax-exempt bonds and tax-exempt bond funds. For the former, you need to know about discount and premium bonds and their taxation but I'm presuming your question is about funds. There are also individual munis which are not exempt but that's another topic altogether.

[House Blend]

Help me to understand Muni Bonds and taxes. So when you put money into say a state specific CA Tax Exempt Muni Bond fund via a taxable account.

You pay neither Federal nor State taxes on the income, correct?

But when you withdraw the money from the fund you will have to pay capital gains taxes either ST or LT, right?

Please educate me here.

There are several moving pieces here.

Since you mentioned California, we can use that as an example. However, there are some states that WILL tax some of their own state's municipal bonds (for example, IL) so make sure you know your state's tax laws.

And since we are talking about CA, it is worth noting that it is unusual in that it is willing to tax CA muni bond interest (and Treasury bond interest) when the bonds are held inside of a mutual fund.

California's law is that if you own shares of any mutual fund whatsover, then all dividends distributed from that fund are 100% CA taxable unless at least 50% of the underlying assets produce interest that would be tax exempt if held individually.

(So for example, a diversified national muni bond fund will produce dividends that are 100% taxable by CA. Admittedly a moot point, given that the OP appears to be looking at CA muni funds only.)

[pshonore]

As I recall, a cap loss on muni bond funds held less than 6 months is non-deductible so be careful if you TLH.

[DSInvestor]

Note that while tax exempt interest is not taxable, it counts as income for some things. For example, non-taxable interest is included in your "combined income" to determine how much of your social security benefits is taxable. See SSA.GOV page - Benefits Planner: Income Taxes and Your Social Security Benefits: https://www.ssa.gov/planners/taxes.html

I believe Medicare MAGI also counts non-taxable interest.

[Artsdoctor]

As I recall, a cap loss on muni bond funds held less than 6 months is non-deductible so be careful if you TLH.

Actually, the Bogleheads looked into this and we ultimately came to the conclusion that is not so! Truly one of the highlights of the forum.

If your municipal bond fund is accruing interest on a daily basis, you are NOT subject to the 6-month rule. Vanguard bond funds are usually accruing interest daily but if you have any questions pertaining to your particular fund, you can log on and click the Balance By Date tab, and you'll see the accrued interest prior to the end-of-month distribution.

There ARE municipal bond funds are do NOT accrue interest daily so it's something to keep in mind when you're building your portfolio.

[Artsdoctor]

Note that while tax exempt interest is not taxable, it counts as income for some things. For example, non-taxable interest is included in your "combined income" to determine how much of your social security benefits is taxable. See SSA.GOV page - Benefits Planner: Income Taxes and Your Social Security Benefits: https://www.ssa.gov/planners/taxes.html

I believe Medicare MAGI also counts non-taxable interest.

Yes, tax-exempt interest is definitely counted in your MAGI. This is why people who own individual premium municipal bonds must amortize even in-state bonds in order to decrease your MAGI if you're somewhere in the neighborhood of those MAGI breakpoints which can influence your Medicare premiums. This is one of those examples where only $1 in increased MAGI can result in hundreds of dollars in extra taxes/surcharges.

[House Blend]

As I recall, a cap loss on muni bond funds held less than 6 months is non-deductible so be careful if you TLH.

Actually, the Bogleheads looked into this and we ultimately came to the conclusion that is not so! Truly one of the highlights of the forum.

If your municipal bond fund is accruing interest on a daily basis, you are NOT subject to the 6-month rule. Vanguard bond funds are usually accruing interest daily but if you have any questions pertaining to your particular fund, you can log on and click the Balance By Date tab, and you'll see the accrued interest prior to the end-of-month distribution.

There ARE municipal bond funds are do NOT accrue interest daily so it's something to keep in mind when you're building your portfolio.

Funny. I just brought this up in another thread just a few minutes ago.

Just so that people don't get the wrong impression about what "not so" means, and what "usually" means, it is important to note that the 6 month rule does apply to dividends from Vanguard's Tax Exempt Bond Index (VTEAX and the ETF).

[heartwood]

As I recall, a cap loss on muni bond funds held less than 6 months is non-deductible so be careful if you TLH.

Actually, the Bogleheads looked into this and we ultimately came to the conclusion that is not so! Truly one of the highlights of the forum.

If your municipal bond fund is accruing interest on a daily basis, you are NOT subject to the 6-month rule. Vanguard bond funds are usually accruing interest daily but if you have any questions pertaining to your particular fund, you can log on and click the Balance By Date tab, and you'll see the accrued interest prior to the end-of-month distribution.

There ARE municipal bond funds are do NOT accrue interest daily so it's something to keep in mind when you're building your portfolio.

Can you provide a link either in this forum or in Pub 550 or elsewhere?

To me its a very arcane issue but seems clear in Pub 550. I sold a Vanguard LT state tax exempt fund in 2016 on three separate dates. I received a 1099-B that showed 4 different line items, one sale date broken into two. The second of that line item had a wash-sale amount listed in Box 1g. It amounted to about 0.05% of the total annual sale transactions or mid-2 digit dollars, i.e., about $50 as a wash sale amount. YMMV but it was not worth my time or my CPA's to question Vanguard.

From your comment you suggest it is a case of understanding how your fund accrues interest, but its seems to remain an item to understand before you invest.

Edit: I just checked as you suggest and find that the fund is accruing dividends.

[dave_k]

As I recall, a cap loss on muni bond funds held less than 6 months is non-deductible so be careful if you TLH.

Actually, the Bogleheads looked into this and we ultimately came to the conclusion that is not so! Truly one of the highlights of the forum.

If your municipal bond fund is accruing interest on a daily basis, you are NOT subject to the 6-month rule. Vanguard bond funds are usually accruing interest daily but if you have any questions pertaining to your particular fund, you can log on and click the Balance By Date tab, and you'll see the accrued interest prior to the end-of-month distribution.

There ARE municipal bond funds are do NOT accrue interest daily so it's something to keep in mind when you're building your portfolio.

I just checked this for the VWIUX and VWLUX I hold (intermediate & long term national muni funds), and it does show some accrued dividends, so I assume that the 6 month rule does not apply to these, correct? It's not much of an issue since I'm at about 5 months, and they are up, but it's good to know.

I am considering doing TLH with these if they drop. Will that work if they are short term losses?

[Good Listener]

Also I need to inform you that the muni funds have distributed both LT and ST capital gains distributions for the last several years and although I don't understand why will continue to do so if rates rise even slowly. Already for example the NJ long term fund has 4 cents per share in realized gains.

This is imprecise. The Vanguard (national) Intermediate Tax-Exempt Fund hasn’t distributed any capital gains since 2002 and so far this year has a realized capital loss. The Limited-Term Tax-Exempt and Short-Term Tax-Exempt Funds have distributed no capital gains in more than five years. The national Long-Term fund has distributed some capital gains in the last three years. I can’t speak to state-specific funds, although they are mostly long-term.

You are correct. Thank you for the clarification. I was limiting my thoughts to my NJ long term fund.

[weltschmerz]

deleted

[dave_k]

Long-term capital gain distributions can be offset against any losses generated by a sale; short-term capital gain distributions cannot and must be counted as taxable income.

If you have capital losses, can't short term losses or remaining long term losses be used to offset short term gains? And then up to $3000 of ordinary income if there's any left?

[House Blend]

Long-term capital gain distributions can be offset against any losses generated by a sale; short-term capital gain distributions cannot and must be counted as taxable income.

If you have capital losses, can't short term losses or remaining long term losses be used to offset short term gains? And then up to $3000 of ordinary income if there's any left?

There's a difference between capital gains distributed by a fund and capital gains realized when you sell shares.

LT cap gain distributions are treated the same as LT gains from sales; there's a special line for them on Schedule D.

ST cap gain distributions are reported to you on 1099-DIV and treated the same as interest. You use Schedule B to report them on your tax return.

[dave_k]

Thanks, I overlooked the distinction between distributions and gains.

[House Blend]

As I recall, a cap loss on muni bond funds held less than 6 months is non-deductible so be careful if you TLH.

Actually, the Bogleheads looked into this and we ultimately came to the conclusion that is not so! Truly one of the highlights of the forum.

If your municipal bond fund is accruing interest on a daily basis, you are NOT subject to the 6-month rule. Vanguard bond funds are usually accruing interest daily but if you have any questions pertaining to your particular fund, you can log on and click the Balance By Date tab, and you'll see the accrued interest prior to the end-of-month distribution.

There ARE municipal bond funds are do NOT accrue interest daily so it's something to keep in mind when you're building your portfolio.

Can you provide a link either in this forum or in Pub 550 or elsewhere?

To me its a very arcane issue but seems clear in Pub 550. I sold a Vanguard LT state tax exempt fund in 2016 on three separate dates. I received a 1099-B that showed 4 different line items, one sale date broken into two. The second of that line item had a wash-sale amount listed in Box 1g. It amounted to about 0.05% of the total annual sale transactions or mid-2 digit dollars, i.e., about $50 as a wash sale amount. YMMV but it was not worth my time or my CPA's to question Vanguard.

FWIW, the "6 month rule" is completely separate from the wash sale rule. The one thing they have in common is that both require selling securities at a loss.

I believe that neurosphere deserves the credit for "discovering" the exception to the 6 month rule
(i.e., in the same sense that Columbus "discovered" America). See
viewtopic.php?t=174363#p2634098

For more info, see the wiki article on tax loss harvesting, especially Sec.4 and the footnotes.
https://www.bogleheads.org/wiki/Tax_loss_harvesting

[heartwood]

As I recall, a cap loss on muni bond funds held less than 6 months is non-deductible so be careful if you TLH.

Actually, the Bogleheads looked into this and we ultimately came to the conclusion that is not so! Truly one of the highlights of the forum.

If your municipal bond fund is accruing interest on a daily basis, you are NOT subject to the 6-month rule. Vanguard bond funds are usually accruing interest daily but if you have any questions pertaining to your particular fund, you can log on and click the Balance By Date tab, and you'll see the accrued interest prior to the end-of-month distribution.

There ARE municipal bond funds are do NOT accrue interest daily so it's something to keep in mind when you're building your portfolio.

Can you provide a link either in this forum or in Pub 550 or elsewhere?

To me its a very arcane issue but seems clear in Pub 550. I sold a Vanguard LT state tax exempt fund in 2016 on three separate dates. I received a 1099-B that showed 4 different line items, one sale date broken into two. The second of that line item had a wash-sale amount listed in Box 1g. It amounted to about 0.05% of the total annual sale transactions or mid-2 digit dollars, i.e., about $50 as a wash sale amount. YMMV but it was not worth my time or my CPA's to question Vanguard.

FWIW, the "6 month rule" is completely separate from the wash sale rule. The one thing they have in common is that both require selling securities at a loss.

I believe that neurosphere deserves the credit for "discovering" the exception to the 6 month rule
(i.e., in the same sense that Columbus "discovered" America). See
viewtopic.php?t=174363#p2634098

For more info, see the wiki article on tax loss harvesting, especially Sec.4 and the footnotes.
https://www.bogleheads.org/wiki/Tax_loss_harvesting

Thanks!

[Artsdoctor]

Even though that thread regarding the "6-month rule" was almost 2 years ago, it never ceases to amaze me how clever this forum is. I had invested in Vanguard's tax-exempt municipal bond funds for at least 20 years and dutifully obeyed the dreaded "6-month rule"; although there's merit to staying in place and keeping things simple, it's a very cumbersome rule. Neurosphere and others really unearthed incredibly important information that changed the way I invest in those funds.