Municipal Bonds and Taxes: Key Considerations for Investors
Beyond tax-exempt income, other factors can influence outcomes for municipal bond investors seeking to minimize their tax liability.
Key Takeaways
While tax-exempt income is a key feature of munis, other factors, such as taxable distributions, AMT and capital gains, can also influence tax outcomes.
Unlike passive strategies, active managers can use tax-loss harvesting and tax-loss swapping to potentially improve a muni portfolio’s tax advantages.
The exchange-traded fund (ETF) structure can further enhance the tax benefits associated with municipal bond funds.
Every year, one of the most important meetings on my calendar was simply labeled “Taxes with Tony.” Tony was my CPA for many years, and these annual meetings became more than a routine review of tax forms. We would catch up on life, then turn to work — and eventually to municipal bonds (munis).
Given my job, I wanted confidence that everything in my portfolio was receiving the correct tax treatment. From capital appreciation bonds to out of state municipals to mutual fund and ETF income, tax strategy was crucial — and not just at tax time.
I never knew whether that attention made me an interesting or high-maintenance client, but Tony never seemed to mind. He appreciated the detail and my focus on tax strategy versus simply tax filing.
While municipal bonds are powerful tools for generating tax advantaged income, their details matter. Portfolio structure, investment vehicles, market activity and even modest exposure to certain bond types can meaningfully influence tax outcomes.
Three Tax-Related Factors That Shape Municipal Bond Investing
Tax-exempt income is a key advantage of municipal bonds. But investors are often surprised to learn how other factors, including strategy, structure and market conditions, can affect tax outcomes.
In our view, maintaining tax awareness requires understanding three topics:
Tax-loss harvesting1
ETF tax efficiency
Sources of unexpected taxable income
Tax-Loss Harvesting: A Powerful Feature of Active Muni Management
Tax loss harvesting involves selling an investment at a loss to offset realized capital gains or, in some cases, a portion of ordinary income. Investors can typically carry forward unused losses to future tax years.
While commonly associated with equities, tax-loss harvesting can be especially effective in municipal bond portfolios. Here’s why:
Predictable pricing trends. Changes in interest rates typically push bond prices in the opposite direction. For example, when yields rise, bond prices tend to fall. These rate-driven price declines can lead to realized losses, even when underlying credit fundamentals remain sound.
Defined maturity value. Bonds differ from stocks in that they have a defined maturity value. A muni trading at a discount price due to higher interest rates may still mature at par value. This means investors may harvest a loss, reinvest in a similar bond and maintain comparable economic exposure. In other words, the investor can capture the tax benefit without meaningfully changing the portfolio’s risk profile.
Muni market’s scope. The size and fragmentation of the municipal market further enhance tax-loss-harvesting opportunities. With thousands of individual bonds outstanding, investors can often sell one security and reinvest in a similar — but not “substantially identical” — bond. This can help avoid the IRS’s wash sale rules while remaining fully invested.2
How Tax-Loss Harvesting Can Influence After-Tax Outcomes
In practice, the benefits for fixed-income investors can be meaningful. Research suggests that systematic tax-loss harvesting can add 0.3% to 1% annually in after-tax value, depending on market volatility and investor tax rates.3
During periods of rising rates, reinvesting harvested losses in higher-yielding municipal bonds can also increase future tax-free income potential. This is commonly referred to as a tax-loss swap.
Consider an investor who realizes a $10,000 capital loss during a rate-driven sell-off in a municipal bond fund. At a combined federal capital gains and net investment income tax rate of 23.8%, that loss can offset approximately $2,380 in taxes.
Additionally, the investor can use realized losses to offset realized capital gains elsewhere in the portfolio. This can help reduce overall tax liability without materially changing portfolio exposure.
How Tax Awareness Fits into Active Muni Management
Tax-loss harvesting also interacts closely with portfolio turnover and liquidity management. Funds with higher turnover or those experiencing persistent outflows may realize gains and losses for reasons unrelated to tax optimization.
Conversely, an active, tax-aware process seeks to harvest losses intentionally, while minimizing unnecessary gains. In our view, tax-loss harvesting represents part of an active manager’s value proposition rather than a passive byproduct of market volatility. Incorporating tax considerations into day-to-day portfolio decisions can help set more realistic expectations for after-tax returns and avoid surprises at filing time.
ETF Tax Efficiency: Why Structure Matters
A portfolio’s structure plays a critical role in taxable distributions. The ETF structure typically offers meaningful tax advantages relative to mutual funds because of how ETFs handle investor flows and portfolio transactions.
Most ETF trading occurs in the secondary market, meaning investors buy and sell shares from each other rather than directly from the fund. When redemptions do occur at the fund level, they are typically in-kind exchanges (a direct swap of assets without using cash) with authorized participants rather than cash sales of securities. This allows ETFs to remove low-cost basis holdings without realizing capital gains.
Why Municipal Bond ETFs Tend to Distribute Fewer Gains
Because ETFs generally don’t need to sell bonds to meet daily redemptions, they are less likely to realize gains during routine portfolio management. An investor selling ETF shares doesn’t force the fund to sell bonds. Therefore, liquidity for the investor doesn’t translate into taxable activity for the fund.
Historically, only a small percentage of U.S. ETFs have distributed annual capital gains, compared with actively managed mutual funds.4 Even during volatile markets, most municipal bond ETFs don’t distribute capital gains, while similarly managed mutual funds may distribute gains due to cash redemptions.
For municipal investors, this distinction is especially important. While interest income may be tax exempt, capital gains distributions are fully taxable. Reducing those distributions may lead to more predictable and consistent after-tax outcomes — an advantage that often becomes apparent at filing time rather than at purchase.
Beyond Tax-Exempt Interest: Other Tax Considerations
A common misconception about municipal bond funds is that they all generate only tax free income. In reality, even funds labeled “tax-exempt” can contain sources of taxable income.
Capital Gains
Capital gains distributions represent a common source of taxable income. Muni funds may realize gains when fund managers:
Rebalance the portfolio.
Sell securities to meet redemptions.
Sell securities for credit or other reasons.
These gains pass through to shareholders and are taxable. Higher turnover strategies, mutual funds experiencing sustained outflows and leveraged structures are particularly prone to taxable gains.
Alternative Minimum Tax (AMT)
The income from certain municipal bonds, including private activity bonds that finance airports and housing, is subject to the federal AMT. This tax primarily affects high-income taxpayers with large deductions, hefty capital gains, significant equity compensation or complex tax situations. The AMT framework limits the use of deductions and credits to ensure that high-income individuals pay at least a minimum level of tax.
The AMT system also includes exemption amounts that reduce the portion of income subject to the tax. The One Big Beautiful Bill Act (OBBBA) of 2025 lowered the income levels at which the AMT exemption phases out.
Starting in 2026, the phase out begins at $500,000 for single filers and $1 million for joint filers. By lowering the income thresholds, the OBBBA restored AMT liability to a broader set of high income investors.
Additionally, some municipal funds hold taxable municipal bonds or other taxable securities for liquidity or diversification purposes. Income from these holdings is fully taxable.
Why After-Tax Outcomes Matter More Than Yield Alone
Tax outcomes matter just as much as yield when evaluating municipal bond investments. Specifically:
Munis offer opportunities for tax loss harvesting, particularly during periods of rising rates.
ETF structures can materially reduce the likelihood of taxable capital gains distributions, helping investors avoid unpleasant surprises.
Leverage, turnover and AMT exposure can introduce taxable income — even in portfolios built around tax-exempt bonds.
In our view, a proactive, tax-aware approach to municipal investing, especially during volatile times, can improve after-tax returns. It can also help reduce uncertainty when it’s time to file tax returns.
Authors
Senior Portfolio Manager
Learn about the tax advantages of municipal bonds.
Long- and short-term capital gains are taxed at different rates. Long-term gains may only be offset by long-term losses. Likewise, short-term gains may only be offset by short-term losses.
The IRS wash sale rule prohibits claiming a loss on the sale of a security if the investor purchases a “substantially identical” security 30 days before or after the sale.
Shomesh E. Chaudhuri, Terence C. Burnham, and Andrew W. Lo, “An Empirical Evaluation of Tax-Loss Harvesting Alpha,” Financial Analysts Journal 76: No. 3 (June 2020).
Brendan McCann, “Few ETFs Project Capital Gains Distributions in 2025: Key Takeaways for Investors,” Morningstar, December 11, 2025.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Diversification does not assure a profit nor does it protect against loss of principal.
Generally, as interest rates rise, the value of the bonds held in the fund will decline. The opposite is true when interest rates decline.
Even though a tax-free bond fund is designed to purchase assets exempt from federal taxes, there is no guarantee that all of the fund’s income will be exempt from federal income tax or the federal alternative minimum tax (AMT). Fund managers may invest assets in debt securities with interest payments that are subject to federal income tax and/or federal AMT. State and local taxes may also apply.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Exchange Traded Funds (ETFs) are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.