Tax-Exemption from State Income Taxes


August 22, 2011

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Happily enough, municipal bonds can also be free of state income taxes. As a general rule in most states, if the bonds are issued in a particular state, it is exempt from that state’s income taxes.

For instance, a bond issued by a municipality in New York will be exempt from New York state income taxes. Since there are 50 states plus D.C. and territories such as Puerto Rico, US Virgin Islands, Guam, it is not possible for us to go over examples involving each state. We’ll go over some basic concepts and cover certain states.

First, having the benefit of not paying state income taxes on top of not having to pay federal income taxes increases the taxable-equivalent yield even more. The higher a state’s income tax, the greater the likelihood of in-state buyers to buy their state’s bonds. Conversely, states without an income tax have to offer slightly higher yields to attract both in-state and out-of-state buyers.

Bonds From Puerto Rico, Guam, and US Virgin Islands

No state can tax bond interest issued by US territories. A resident of any state can buy bonds issued by the territories and have the interest tax-exempt from their state’s income taxes.

States with No Income Taxes: Washington, Texas, Florida, Alaska, South Dakota, Wyoming, Nevada

The states listed above have no income taxes, which means a couple of things:

  1. If you live in one of these states, you can be indifferent as to whether the bonds are issued in your state or not.
  2. Many times, you will notice that states with no income tax offer slightly higher yields. This is to offset for the fact that their bonds are not specifically attractive to their own citizens since there is no local tax benefit.

New York City Has a City Income Tax

Municipal bonds issued in the state of New York are exempt from city and state income taxes. Municipal bond interest from bonds issued in the state may be triple tax-exempt from city, state, and federal income taxes.

Utah Reciprocates Taxation

Utah does not tax its own bonds, but also does not tax bonds issued in states that do not tax Utah bonds. Basically, if a state does not collect taxes on Utah’s bonds, Utah does not collect interest on that state’s bonds. This means that residents of Utah can buy bonds from states with no income taxes such as Texas bonds, Washington state bonds, etc. and not pay Utah state income taxes on the interest.

Washington D.C.

Our capital’s district does not tax in-state or out of state municipal bonds. This means Washington D.C. residents can buy bonds from anywhere and not pay state or district income taxes on the interest.

Oklahoma, Kansas, Iowa, Wisconsin, and Illinois

These states tax in-state bonds in most instances and out-of-state bonds as well. There are a few exceptions. For the most part, residents of these states should look at bonds from other states with the same regard as bonds issued within the their states. You will likely have to pay state income tax either way.

For most other states, the basic rule is that only interest from bonds issued within the state is exempt from that state’s income taxes.

Bottom Line

It is not necessary to be obsessed with having your bonds be exempt from state income taxes. The bulk of your tax savings are going to result from not having to pay federal income taxes. When it comes to state taxation, a smarter bet would be to diversify your portfolio across many states. It may cost you a bit in terms of state income taxes, but your portfolio would not be subject to risks that are isolated geographically. Additionally, having a much bigger pool of bonds to choose from when you look across all states is invariably going to allow you to find a few bonds that will yield enough to offset having to pay state income taxes.

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NOTE: It should be noted that interest from US treasury bonds are exempt from state income taxes. When you are comparing a municipal bond that may be taxable in your state with a US treasury bond, you should account for the fact that the US Treasury bond’s interest is exempt from your state’s income taxes.

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