Municipal Bonds Explained: Tax-Free Income for High Earners

For investors in higher tax brackets, municipal bonds, often called munis, can be an attractive source of income. Their main appeal is that interest is often exempt from federal income tax and sometimes from state and local taxes as well. For high earners facing high marginal tax rates, that tax advantage can make municipal bonds more valuable than taxable bonds with higher stated yields.

What municipal bonds are

Municipal bonds are debt securities issued by states, cities, counties, school districts, transportation authorities, utilities and other government entities. These issuers use the money to fund public projects, such as schools, roads, bridges, hospitals, water and sewer systems and airports, or for general government operations.

When you buy a municipal bond, you’re lending money to the issuer. In return, the issuer generally pays you interest, typically every six months, and repays your principal when the bond matures.

There are two main types of municipal bonds. General obligation bonds are backed by the full faith and credit of the issuer, which typically means the issuer’s taxing power. Revenue bonds are backed by revenue from a specific project or source, such as tolls from a highway, fees from a utility or revenue from a hospital. Revenue bonds may carry more risk, since repayment depends on the success of the specific project.

The tax advantage

Interest from most municipal bonds is exempt from federal income tax. This is the primary reason high earners are drawn to them.

If you buy bonds issued in your own state, the interest may also be exempt from state and local income taxes, making them especially attractive for residents of high-tax states. Bonds issued by U.S. territories, such as Puerto Rico, may be exempt from state taxes in all states.

There are some exceptions. Some municipal bonds, called private activity bonds, may be subject to the alternative minimum tax. Some munis are taxable, such as those issued for purposes that don’t qualify for tax exemption. And if you buy a muni at a discount or sell it for a gain, capital gains taxes may apply.

Municipal bond interest isn’t counted as net investment income for purposes of the 3.8% net investment income tax, which adds to their appeal for high earners. However, tax-exempt interest is included in calculations that determine how much of your Social Security benefits are taxable.

Calculating tax-equivalent yield

Because munis offer tax advantages, comparing their yields directly with taxable bonds can be misleading. A muni with a lower stated yield may actually provide more after-tax income than a taxable bond with a higher yield.

To compare a muni with a taxable bond, calculate the tax-equivalent yield using this formula: muni yield divided by one minus your tax rate.

If the muni is also exempt from state taxes, the tax-equivalent yield is even higher, since you’d include your state tax rate in the calculation.

The higher your tax bracket, the more valuable the tax exemption becomes. For investors in lower tax brackets, taxable bonds may provide higher after-tax income.

Risks of municipal bonds

While municipal bonds have historically had relatively low default rates compared with corporate bonds, they still carry risks.

Interest rate risk means bond prices fall when interest rates rise. Longer-term bonds are more sensitive to rate changes.

Credit risk means some issuers may face financial trouble and be unable to make payments. While defaults have been relatively rare, some municipalities have experienced financial distress. Credit ratings from agencies like Moody’s, S&P Global and Fitch help assess risk.

Call risk means some bonds can be repaid early by the issuer, often when interest rates fall, forcing you to reinvest at lower rates.

Liquidity risk means some individual municipal bonds trade infrequently and can be hard to sell quickly at a fair price.

Inflation risk means fixed interest payments may lose purchasing power over time.

Tax law changes could also affect the value of the tax exemption.

Ways to invest in municipal bonds

You can buy individual municipal bonds through a broker. Individual bonds let you hold to maturity and receive your principal back, assuming no default, and choose specific issuers and maturities. However, building a diversified portfolio of individual bonds may require significant capital, and transaction costs can be higher for smaller purchases.

Municipal bond funds and ETFs offer diversification across many issuers, professional management and easier trading. National funds hold bonds from many states, while state-specific funds focus on bonds from a single state to maximize state tax benefits. Bond funds don’t have a maturity date, so their value fluctuates with interest rates.

Research individual bonds on the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access website, known as EMMA, which provides free access to official statements, trade prices and disclosure documents.

Where to hold munis

Because their main benefit is tax exemption, municipal bonds generally belong in taxable accounts. Holding munis in tax-advantaged accounts like IRAs wastes their tax advantage, since income in those accounts is already tax-deferred or tax-free.

Is it right for you?

Municipal bonds can be a valuable part of a portfolio for high earners seeking tax-efficient income and stability. A fee-only financial adviser or tax professional can help you evaluate whether munis fit your goals and tax situation.

This article is for education only and isn’t investment advice.