Ordinarily, you have to pay tax on the income you earn on your investments each year. For example, if you have a savings account and earn $1,000 in interest, you must add it to your taxable income and pay tax on it. However, some types of investments are wholly or partly tax free—that is, you don’t pay tax on the interest or other income you receive from the investment. Bonds issued by state and local governments are the long-time mainstay of tax-free investing (U.S. government bonds and notes have some tax-free attributes as well).
Issuing bonds is one of the main ways that corporations and governments raise money. When you purchase a bond you are essentially loaning money to the bond issuer for a period of time. The issuer promises to make regular interest payments at a pre-established interest rate (called the coupon rate) and to repay the face amount of the bond when it comes due. The interest you are paid by a bond issuer is ordinarily taxable income, but some types of bonds are wholly or partly tax free.
As the name indicates, municipal bonds are used by state, city, or local governments, and by other government entities such as water and sewer districts or turnpike authorities. The money raised from these bonds may be used to fund regular government activities, or to pay for specific projects, such as building roads, sewer systems, schools, or hospitals.
Interest earned from municipal bonds is ordinarily exempt from federal tax. The federal government does this to help state and local governments raise money more cheaply. Municipal bonds are also exempt from state tax if the bond purchaser lives in the state that issued the bond.
Example: Art, an Illinois resident, purchases a municipal bond issued in Michigan. He must pay Illinois state income tax on the interest he earns on this out-of-state bond.
Muni bonds are exempt from local taxes as well if the purchaser lives in the city, county, or other locality that issued the bond.
The moral: Buy muni bonds issued in your home state, or your locality.
If you sell a municipal bond at a profit (called a capital gain), you must pay federal and state tax on the amount. However, most of the money earned from bonds comes from the interest they pay, not capital gains.
Because municipal bonds are tax free, they pay lower interest than bonds whose interest is taxable. But, depending on your top tax rate, municipal bonds can provide a greater after-tax return than taxable bonds. For example, if you’re in the 28% tax bracket, a muni bond earning 4% interest would end up paying you as much as a taxable bond earning 5.56% after you pay the taxes on the interest. The higher your tax bracket, the better will be your total return (yield) from a tax-free municipal bond. This makes muni bonds most attractive for wealthy people who pay high taxes.
U.S. Government bonds, notes, and bills
The federal government in Washington, D.C. needs to borrow money—quite a bit of money. To accomplish this, it issues its own bonds. These are long term Treasury bonds, and shorter term Treasury bills and notes. Interest income from Treasury bills, notes, and bonds is subject to federal income tax, but is exempt from all state and local income taxes. Both notes and bonds generally pay interest every six months and you usually report this interest for the year paid.