FINRA Series 7Investment Information and Suitable RecommendationsEasy
A client in the 32% federal tax bracket asks her registered representative why municipal bond interest is attractive compared with a corporate bond paying a similar coupon. Which statement best explains the primary tax advantage?
- AMunicipal bond interest is exempt from federal income tax
- BMunicipal bonds are guaranteed by the U.S. Treasury
- CMunicipal bond interest is exempt from all state and local taxes regardless of residency
- DCapital gains on municipal bonds are always tax-free
Show answer & explanationAnswer & explanation
Correct answer: A. Municipal bond interest is exempt from federal income tax
Interest income from municipal bonds is generally exempt from federal income tax, making them attractive to investors in higher tax brackets. State/local tax exemption depends on residency, capital gains on munis are still taxable, and munis are not federally guaranteed.
Why the other options are wrong
- B. Incorrect — munis carry issuer credit risk and are not backed by the U.S. Treasury.
- C. Incorrect — state/local exemption only applies if the investor resides in the issuing state (double exemption), not universally.
- D. Incorrect — any capital gain from selling a muni bond above cost basis is taxable.
Municipal Bond Tax Exemption
Interest paid on municipal bonds is exempt from federal income tax, and may also be exempt from state/local tax if the investor resides in the issuing state.
- Federal interest exemption applies regardless of residency
- Double exemption requires in-state residency
- Capital gains on munis are still taxable
- Munis are not government-guaranteed
Memory trick: Muni interest is 'Uncle Sam-free' but not 'gain-free.'