Local and state governments sell bonds to borrow money. Collectively, these debt securities are called municipal bonds. The Financial Industry Regulatory Authority says that munis, as municipal bonds are often called, are the only bonds that pay tax-free interest. However, interest on some bonds issued by state and local government us taxable.
Benefit to the General Public
The interest on most municipal bonds is exempt from federal income tax. Exemption is not automatic. The money raised from selling the bonds must be used for something that benefits the general public. For example, bonds sold to finance a new school, hospital or road qualify since everyone in the community can benefit. However, bonds sold to fund a state employee pension plan or to build a sports arena don't meet the federal criteria.
If you are a resident of the state in which a municipal bond is issued, you may not have to pay state or local income taxes on the interest income.
The Investor's Perspective
The interest rate, or yield, on a tax-free municipal bond is typically lower than taxable Treasury or corporate bond yields. A muni is an attractive choice for the investor when the after-tax yield on taxable bonds is less than the municipal bond tax-free yield. Consequently, the higher your tax bracket on your income, the more likely it is that a particular municipal bond will work to your advantage.
A Note About Capital Gains
If you buy a municipal bond and later sell it for more than the purchase price, you realize a capital gain, so if you buy a muni for $4,700 and sell it for $4,850. You have a $150 capital gain. Capital gains on the sale of municipal bonds are taxable even if the interest is entirely tax-free.