Tax-Exempt Interest Explained

Tax-exempt interest is income from certain bonds and investments that you do not have to report to the IRS or pay federal income tax on. The most common source is municipal bonds — debt issued by states, cities, and other local governments to fund schools, roads, water systems, and other public projects. When you own a municipal bond, the interest it pays you is typically free from federal tax, and sometimes from state and local tax as well.

The reason these bonds carry tax-free interest is straightforward: the government wants to encourage lending to public projects. By making the interest tax-free, the bonds attract investors even though they pay lower interest rates than taxable bonds. A municipal bond paying 3 percent tax-free can be worth more to you than a corporate bond paying 4 percent, depending on your tax bracket.

Not all tax-exempt interest comes from municipal bonds. U.S. savings bonds (Series EE and Series I) can also produce tax-exempt interest under certain conditions — specifically if you use the proceeds to pay for higher education. Interest on bonds issued by Native American tribal governments and certain other government entities may also be tax-free.

Key Takeaways

  • Municipal bonds issued by states, cities, and local governments produce interest that is free from federal income tax and sometimes state and local tax as well.
  • Tax-exempt interest is lower than taxable interest because investors accept a smaller return in exchange for the tax savings.
  • Series EE and Series I savings bonds can produce tax-exempt interest if the money is used to pay for may have access to education expenses.
  • You must still report tax-exempt interest on your tax return, even though you do not owe tax on it.
  • Tax-exempt bonds make the most financial sense if you are in a higher tax bracket, because the tax savings are larger.

How Municipal Bonds Create Tax-Free Income

When a city or state issues a municipal bond, it is borrowing money from investors like you. In return, it promises to pay you interest on that loan. Because the bond is issued by a government body, the federal government exempts the interest from income tax. Most states also exempt interest on bonds issued within that state from state income tax.

The interest rate on a municipal bond is almost always lower than the rate on a comparable corporate bond or Treasury bond. This is the trade-off: you accept less interest in exchange for not paying tax on it. Whether that trade-off makes sense depends on your tax bracket. If you are in the 24 percent federal tax bracket, a 3 percent tax-free municipal bond is worth about the same as a 3.95 percent taxable bond. If you are in the 35 percent bracket, that same 3 percent tax-free bond is worth about 4.6 percent taxable.

Municipal bonds come in two main types: general obligation bonds, which are backed by the government's taxing power, and revenue bonds, which are backed by income from a specific project (like tolls on a highway or fees at a water utility). Both types produce tax-exempt interest, though revenue bonds typically carry slightly higher risk and higher interest rates.

Savings Bonds and Education-Related Tax Exemptions

Series EE and Series I savings bonds are issued by the U.S. Treasury and normally produce taxable interest. However, if you meet specific conditions, you can exclude that interest from your income entirely. The main condition is that you must use the bond proceeds to pay for may have access to education expenses — tuition and fees at an accredited college, university, or vocational school, or contributions to a 529 education savings plan.

To claim this exemption, you must have purchased the bonds in your own name (not as a gift for someone else), and you must have been at least 24 years old when you bought them. You must also redeem the bonds in the same year you pay the education expenses, or in the year when ready before. The education expenses must be for you, your spouse, or your dependent.

This exemption is less commonly used than municipal bonds because the conditions are strict and the bonds must be redeemed in a specific window. However, if you are planning to pay for college and want a safe, government-backed way to set aside money, Series I bonds in particular can be attractive because they adjust for inflation.

Why You Still Report Tax-Exempt Interest on Your Tax Return

Even though you do not owe tax on tax-exempt interest, you must still report it on your federal tax return. The IRS requires you to list it on Form 1040, line 2a, under "Interest." This is true even if the amount is small. The reason is that tax-exempt interest can affect other parts of your tax situation — for example, it can push you into a higher tax bracket for purposes of calculating tax on Social Security benefits, or it can reduce the amount of education credits you can claim.

Your broker or the bond issuer will send you a Form 1099-INT showing the interest you received. Make sure the amount is correct before you file. If you own municipal bonds through a mutual fund or exchange-traded fund, the fund will report the tax-exempt interest to you, and you report it the same way.

When Tax-Exempt Bonds Make Financial Sense

Tax-exempt bonds are most valuable to people in higher tax brackets. If you are in the 12 percent federal tax bracket, the tax savings from a municipal bond are modest, and you might earn more by buying a taxable bond instead. If you are in the 35 percent bracket, the tax savings are substantial, and a municipal bond becomes much more attractive.

Your state of residence also matters. If you buy a municipal bond issued in your home state, you typically avoid both federal and state income tax on the interest. If you buy a bond issued in another state, you usually pay state tax on the interest (though you still avoid federal tax). Some high-tax states like New York and California make in-state municipal bonds especially valuable.

Tax-exempt bonds also make sense if you are in a period of high income — for example, if you sold a business or received a large bonus. Using some of that money to buy municipal bonds can reduce your tax bill for that year and provide steady, predictable income going forward.

The Trade-Off Between Safety and Yield

Municipal bonds are generally considered safe investments because they are backed by government revenue or specific projects. However, not all municipalities are equally creditworthy. Before you buy a municipal bond, check its credit rating. Bonds rated AAA or AA by Standard & Poor's or Moody's are considered very safe. Bonds rated BBB or lower carry higher risk of default, which means the issuer might not pay you back.

The lower interest rate on tax-exempt bonds compared to taxable bonds reflects this safety. You are accepting a smaller return in exchange for tax savings and lower risk. If you want higher yield, you can buy municipal bonds issued by less creditworthy municipalities, but this increases the chance you will not receive all your interest or principal back.

If you are buying individual bonds, buy them through a broker and ask for the credit rating and financial statements of the issuer. If you prefer to avoid this research, you can buy a municipal bond mutual fund or exchange-traded fund, which spreads your money across many bonds and reduces the risk that any single issuer will default.

Tax-Exempt Interest and Your Overall Tax Picture

Tax-exempt interest can interact with other parts of your taxes in ways that matter. If you receive Social Security benefits, tax-exempt interest counts toward the "combined income" threshold that determines how much of your benefits are taxable. If you are claiming education credits like the American Opportunity Credit or Lifetime Learning Credit, tax-exempt interest reduces your modified adjusted gross income, which can affect the amount of the credit.

This means that buying a municipal bond to save on income tax might actually cost you money if it pushes you over a threshold that reduces other tax benefits. Before you buy a large amount of tax-exempt bonds, consider running the numbers with a tax professional to see how it affects your overall tax situation.

Frequently Asked Questions

Do I have to pay state tax on municipal bond interest?

It depends on where the bond was issued and where you live. If you buy a municipal bond issued in your home state, you typically pay no state income tax on the interest. If you buy a bond issued in another state, you usually owe state tax on the interest, though you still avoid federal tax. A few states do not tax municipal bond interest at all, regardless of where the bond was issued.

Can I lose money on a municipal bond?

Yes. If you hold the bond to maturity, you get your principal back (assuming the issuer does not default). But if you sell the bond before maturity, its price may have fallen, and you will take a loss. Bond prices fall when interest rates rise, because new bonds paying higher rates become more attractive. You can also lose money if the issuer defaults and cannot pay you back.

What is the difference between a municipal bond and a Treasury bond?

Both are issued by government bodies, but Treasury bonds are issued by the federal government and are backed by the full faith and credit of the United States. Municipal bonds are issued by states and cities and are backed by their revenue or specific projects. Treasury bonds are considered safer, but their interest is taxable. Municipal bond interest is tax-free federally.

Can I buy municipal bonds through my brokerage account?

Yes. Most brokers allow you to buy individual municipal bonds or municipal bond mutual funds and exchange-traded funds. If you buy individual bonds, you typically pay a small markup or commission. If you buy a fund, you pay an annual expense ratio. Ask your broker about the costs before you buy.

Is tax-exempt interest really information programs?

No. You are accepting a lower interest rate in exchange for the tax savings. Whether that trade-off is worth it depends on your tax bracket and your other income. In some cases, a taxable bond paying a higher rate will leave you with more money after taxes than a tax-exempt bond paying a lower rate.