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Question

Difficulty: Very hardGovernment, Municipal, and Corporate Bonds

An investor residing in Illinois, currently in a 32%32\% federal marginal income tax bracket and a 4.95%4.95\% state income tax bracket, purchases two fixed-income securities: an out-of-state municipal revenue bond paying a 4.50%4.50\% annual coupon and a U.S. Treasury note paying a 5.00%5.00\% annual coupon. Which of the following statements accurately describes the tax treatment of the interest income generated by these securities for this investor?

  1. The interest from the municipal revenue bond is exempt from federal income tax but subject to state income tax, while the interest from the U.S. Treasury note is subject to federal income tax but exempt from state income tax.Answer
  2. B
    The interest from both the municipal revenue bond and the U.S. Treasury note is exempt from state income tax, but only the U.S. Treasury note interest is exempt from federal income tax.
  3. C
    The interest from the municipal revenue bond is completely tax-free at both federal and state levels regardless of the issuing state, while the U.S. Treasury note interest is fully taxable at both levels.
  4. D
    The interest from both securities is subject to federal income tax, but the out-of-state municipal revenue bond interest is exempt from state income tax due to federal reciprocity agreements.

Answer

The interest from the municipal revenue bond is exempt from federal income tax but subject to state income tax, while the interest from the U.S. Treasury note is subject to federal income tax but exempt from state income tax.
Interest earned on municipal bonds is exempt from federal income tax, but out-of-state municipal interest is subject to state income tax in the investor's home state. In contrast, interest earned on U.S. Treasury securities is subject to federal income tax but exempt from all state and local income taxation.

Step-by-Step Solution

1
Analyze the federal and state tax characteristics of municipal debt for out-of-state residents.
Municipal bond interest is federally tax-exempt. However, because the bond was issued by an out-of-state municipality, the investor's home state (Illinois) levies state income tax on the interest.
State tax exemption for municipal debt generally applies only to bonds issued within the investor's state of residence or U.S. territories.
2
Analyze the federal and state tax characteristics of U.S. Treasury obligations.
Interest earned on U.S. Treasury securities (Bills, Notes, Bonds) is subject to federal income tax, but strictly exempt from state and local income taxes.
Federal law prohibits state and local governments from taxing interest income derived from direct federal government debt obligations.
3
Synthesize the tax rules to determine the correct tax status for both instruments.
Municipal Revenue Bond: Federal exempt / State taxable; U.S. Treasury Note: Federal taxable / State exempt.
This reflects the precise legal tax boundaries established for municipal and federal debt obligations.

Key Concept

Taxation rules for Municipal Debt vs. U.S. Treasury Securities
Estimated Time:1m 30s
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Topics

Government, Municipal, and Corporate Bonds

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