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Muni Bond Market Survives Challenge

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UPDATE: The U.S. Supreme Court has ruled that states can retain the current system that allows exemption of income from state income tax of certain municipal bonds.

The Court ruling took out of jeopardy one of the main selling points of municipal bonds: exemption from state income tax if the bondholder buys an issue from the state of his residence.

The interest income from municipal bonds, for the most part, enjoys an exemption from federal income tax. This tax-free income makes the bonds appealing to upper income people.

Most, but not all states, extend an income tax exemption to bonds issued within their borders. The idea is to make local bonds more attractive to residents of the state.

Lower Cost

The bonds can be offered at a slightly lower cost to the issuer because of the extra tax exemption.

If you buy a municipal bond in the state where you live and the state exempts the interest from income taxes, you have a truly tax-free income.

For high-income investors in states with high income tax rates, this is a real benefit. It also works well for those taxpayers who may not be at the very top of the marginal tax rates, but are close.

The case in question challenged Tennessee’s right to tax the income of bonds issued from municipalities outside its borders while exempting income from bonds issued from within its borders.

Supreme Court

Lower courts had ruled in favor of the plaintiffs and Tennessee asked the Supreme Court to hear its appeal.

Tennessee got the lower court’s ruling overturned by the Supreme Court, so things will remain the same.

However, if the high court had ruled in favor of the plaintiff, Tennessee and the other states that tax out of state bonds would have faced a choice.

They could have begun taxing all bonds including those issued within their borders or not tax income from any bonds, no matter where they originated.

It is unlikely that states would opt to give up tax dollars and not tax income from any municipal bond.

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