What are Tax-Free Bonds?

When state or local governments decide to borrow money, they typically do so by selling bonds. Collectively, these government debt instruments are known as municipal bonds, or "munis" for short. The interest earned on most municipal bonds is exempt from federal income tax, and sometimes from state and local taxes as well. According to the Financial Industry Regulatory Authority, municipal bonds are the only tax-free bonds.

Municipal bonds usually come in one of two types, depending on the source of the money used to pay for them:

• General obligation bonds. These bonds are backed by the full faith and credit of the issuing government. That is, the taxing power of the government is the source of the funds needed to pay for the bonds.
  
• Revenue bonds. The money for interest and repayment of a revenue bond comes from income generated by a specific project. For example, tolls might be earmarked to pay for municipal bonds sold to fund construction of a new road.
  

Municipal bonds usually pay a fixed amount of interest to investors each year, called a coupon. The coupon is a percentage of the face value, which is the amount an investor receives when the bond is repaid at maturity. However, some municipal bonds don't pay out interest this way. Instead, such bonds are sold at a discount off the face value. Interest accrues until the bond reaches face value at maturity. Either way, municipal bond interest is classified by the Internal Revenue Service as ordinary income, much like wages, dividends or interest on savings accounts, and is taxable if a bond does not qualify for tax-exempt status.

Not all municipal bonds qualify for exemption from federal income taxes on the interest they pay. To qualify, the bond money must be used for a purpose that benefits the general public. Construction of a school, hospital or sewage system are examples of projects that qualify as tax-exempt. However, a bond issue used to shore up an underfunded pension fund or to build a sports arena does not meet federal guidelines as a benefit to the general public, and so the interest on these bonds is not exempt from federal income tax.

Municipal bond interest often is exempt from state and local income taxes as well for bond owners who are residents of the state where the bonds are issued.

Municipal bonds are traded like other securities, such as stocks and corporate bonds. Their prices go up and down. This means you can realize a capital gain from the sale of a muni. Capital gains are not exempt from taxation even when interest is tax free.

Suppose you buy a $5,000 face value municipal bond for $4,500, and eventually sell it for $4,800. Your capital gain of $300 is taxable. If you owned the bond for one year or less, the gain is taxed at the same rates as ordinary income. If you owned the bond for more than one year, lower capital gains tax rates apply.