FINRA Series 7Investment Information and Suitable RecommendationsEasy
A client is considering investing in a municipal bond fund that primarily holds general obligation bonds. Which of the following statements regarding the tax treatment of the interest income from these bonds is MOST accurate?
- AInterest income is always exempt from federal, state, and local taxes.
- BInterest income is exempt from federal tax but may be subject to state and local taxes.
- CInterest income is subject to federal, state, and local taxes.
- DInterest income is subject to federal tax but exempt from state and local taxes.
Show answer & explanationAnswer & explanation
Correct answer: B. Interest income is exempt from federal tax but may be subject to state and local taxes.
Interest from municipal bonds is generally exempt from federal income tax. However, for state and local taxes, the exemption typically applies only if the bondholder resides in the state or locality where the bond was issued.
Why the other options are wrong
- A. This is incorrect; state and local taxes may apply if the investor lives outside the issuing state.
- C. This is incorrect; municipal bond interest is typically exempt from federal tax.
- D. This is incorrect; municipal bond interest is generally federally tax-exempt.
Municipal Bond Tax Treatment
Interest income from municipal bonds is generally exempt from federal income tax. It may also be exempt from state and local taxes if the bondholder resides in the state or locality that issued the bond (the 'triple tax-exempt' feature).
- Federally tax-exempt.
- State/local tax-exempt if investor resides in issuing state/locality (triple tax-exempt).
- Capital gains are always taxable.
- Interest on private activity munis may be subject to AMT.
Memory trick: Fed's Free, State's Home, Capital's Cash.