Tax-exempt interest is a form of income earned primarily from municipal bonds issued by state and local governments to finance public projects. This interest is usually exempt from federal income tax due to its public benefit nature, and it may also be free from state and local taxes if the bond is issued within your state or local jurisdiction. This unique tax treatment allows investors to retain more of their earnings compared to taxable interest from other bonds or investments.

When you purchase municipal bonds, you are effectively lending money to government entities that use these funds for projects like building schools, roads, or hospitals. In return, investors receive interest payments that often avoid federal taxation. However, any capital gains realized from selling these bonds are usually taxable.

Municipal bonds come in two main types: General Obligation (GO) Bonds, which are backed by the full taxing power of the issuer and considered safer, and Revenue Bonds, which are repaid from specific project revenues and generally carry more risk but may offer higher yields.

Tax-exempt interest benefits high-income investors the most, as the tax savings increase with higher tax brackets. Residents investing in bonds from their own state may benefit from “triple-tax-exempt” status, meaning exemption from federal, state, and local income taxes. Additionally, municipal bonds provide a reliable income stream, portfolio diversification, and a way to support local community projects.

Understanding the taxable equivalent yield helps investors compare the after-tax returns of tax-exempt bonds to taxable ones. For example, a 3% tax-exempt yield is equivalent to a 4.62% taxable yield for someone in the 35% federal tax bracket.

Investors should be aware of common misconceptions: not all municipal bonds are tax-exempt, some are subject to the Alternative Minimum Tax (AMT), and the interest must still be reported on tax returns, typically on IRS Form 1040, line 2a. The IRS requires reporting tax-exempt interest even though it is not included in taxable income, as it affects other tax calculations like Social Security benefit taxation.

Pros of tax-exempt bonds include significant tax savings, relative safety, portfolio diversification, and supporting public projects. Downsides include generally lower yields compared to taxable bonds, susceptibility to interest rate and inflation risk, potential liquidity issues, and credit risk.

Tax-exempt interest is a valuable investment tool for many, but selecting the right bonds and understanding tax implications are crucial for maximizing benefits. Consulting with a financial advisor and carefully reviewing bond details, including potential AMT impact, helps ensure the investment fits individual financial goals.

For more on municipal bonds and tax strategies, see our related Municipal Bonds article.

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(Last reviewed June 2025)