Municipal bonds are sold through brokers, not directly from the government, and the tax treatment depends on which state issued the bond and where you live

You cannot buy municipal bonds directly from a city or state the way you buy Treasury bonds from TreasuryDirect. Instead, you buy them through a brokerage account — either a full-service broker, a discount broker like Fidelity or Charles Schwab, or sometimes through a bank. The bonds themselves are issued by municipalities (cities, counties, states, water districts, school districts) to raise money for projects like roads, schools, or hospitals.

The tax treatment is the main reason people buy them. Interest from most municipal bonds is not taxed by the federal government. Interest is also not taxed by your state if you buy a bond issued by a municipality in your own state — this is called the in-state exemption. If you buy a bond from another state, you pay your home state's income tax on the interest, even though you do not pay federal tax.

Whether this tax advantage is worth it depends on your tax bracket and the bond's interest rate compared to taxable alternatives. A municipal bond paying 3 percent may be worth more to you than a Treasury bond paying 3.5 percent if you are in a high tax bracket, because you keep all 3 percent. Someone in a low tax bracket might come out ahead with the higher-paying taxable bond.

Key Takeaways

  • Municipal bonds are bought through a brokerage account, not directly from the government, and you pay a broker's commission or spread when you buy or sell.
  • Interest from municipal bonds is exempt from federal income tax, and also exempt from state income tax if the bond was issued in your home state.
  • The tax advantage only matters if your tax bracket is high enough that the tax savings outweigh a lower interest rate compared to taxable bonds.
  • You can buy new bonds at issuance (called the primary market) or existing bonds from other investors (called the secondary market), and prices and availability differ between the two.
  • Municipal bonds carry credit risk — the issuer might not pay back the principal or interest — so research the issuer's financial health before buying.

Opening a brokerage account and choosing a broker

You need a brokerage account to buy municipal bonds. Most major brokers offer them: Fidelity, Charles Schwab, E*TRADE, TD Ameritrade, Vanguard, and others. You can open an account online in about 15 minutes by providing your name, address, Social Security number, and employment information. The broker will ask what type of account you want — a regular taxable account, an IRA, a 401(k) rollover, or another type.

Different brokers charge different fees for buying and selling municipal bonds. Some charge a flat commission per trade (for example, $25 to $50). Others charge a percentage of the purchase price. Still others use a "markup" or "spread" — they buy the bond at one price and sell it to you at a higher price, pocketing the difference without showing it as a separate line item on your statement. Before opening an account, call or check the broker's website to ask how they charge for municipal bond trades, because this cost directly reduces your return.

If you are buying a large amount (typically $25,000 or more), some brokers will negotiate the fee. If you are buying a small amount, the fee as a percentage of your purchase might be higher, so it is worth comparing.

Buying bonds at issuance versus on the secondary market

When a city or state issues new bonds to raise money for a project, those bonds are sold in the primary market. Your broker can tell you about new issues coming to market and often sells them without charging a commission — the underwriter (the bank managing the sale) pays the broker's fee. This makes new issues cheaper to buy than existing bonds.

Once bonds are issued, they trade between investors on the secondary market. If you want to buy a bond that was issued five years ago, you are buying it from another investor through your broker, who charges a markup. Secondary market bonds may have different prices and yields than when they were first issued, depending on interest rate changes and the issuer's credit quality.

New issues are usually easier and cheaper to buy, but the selection is limited to what is being issued right now. The secondary market has thousands of bonds available at any time, but you pay more to buy them. Your broker can show you both options and explain the cost difference for any specific bond you are considering.

Understanding credit risk and researching the issuer

A municipal bond is only as safe as the government or agency that issued it. If the issuer runs out of money or faces a financial crisis, it might not pay the interest on time or might not return your principal when the bond matures. This is called credit risk.

Before buying, research the issuer's financial health. Three major rating agencies — Moody's, Standard & Poor's, and Fitch — assign credit ratings to municipal bonds. A rating of AAA or AA means very low risk. A rating of BBB or lower means higher risk. Your broker can show you the rating for any bond you are considering. You can also look up the issuer's financial statements and audit reports on the Municipal Securities Rulemaking Board's website (MSRB.org) under the EMMA system (Electronic Municipal Market Access).

Some municipal bonds are backed by insurance — a third party guarantees that if the issuer cannot pay, the insurer will. This raises the bond's rating and lowers its yield. Insured bonds are safer but pay less interest. Uninsured bonds pay more but carry higher credit risk.

Tax-exempt status and which bonds may have access to

Not all municipal bonds are tax-exempt. The IRS allows tax-exemption only for bonds issued to fund specific types of projects: schools, roads, water systems, hospitals, affordable housing, and other public purposes. Bonds issued to fund private businesses or to refinance existing debt sometimes do not may have access to for tax-exemption.

Your broker and the bond's official statement will tell you whether a specific bond is tax-exempt. If it is, the interest is exempt from federal tax. If you buy a tax-exempt bond issued in your home state, the interest is also exempt from your state's income tax. If you buy a tax-exempt bond issued in another state, you owe your home state's income tax on the interest.

A few states do not have income tax (Florida, Texas, Wyoming, and others). If you live in one of these states, you get the federal exemption on any municipal bond, but you do not get an additional state exemption because there is no state income tax to exempt. Residents of high-tax states like California, New York, and Massachusetts benefit most from the in-state exemption.

Calculating whether municipal bonds make sense for your situation

The tax advantage of municipal bonds only matters if your tax bracket is high enough. To compare a municipal bond to a taxable bond, calculate the taxable equivalent yield: divide the municipal bond's interest rate by (1 minus your tax bracket). For example, if a municipal bond pays 3 percent and you are in the 24 percent federal tax bracket, the taxable equivalent yield is 3 ÷ (1 − 0.24) = 3.95 percent. This means the municipal bond paying 3 percent is equivalent to a taxable bond paying 3.95 percent, because you keep all 3 percent instead of paying 24 percent in taxes.

If a taxable bond is paying 3.5 percent, the municipal bond at 3 percent is the better deal for you. If the taxable bond is paying 4.5 percent, the taxable bond is better. Your broker can help you run this calculation, or you can use an online municipal bond calculator.

People in lower tax brackets (10 or 12 percent) often come out ahead with taxable bonds, because the tax savings are smaller and taxable bonds usually pay higher interest rates. People in higher tax brackets (32 percent and above) almost always benefit from municipal bonds.

Holding to maturity versus selling before maturity

Municipal bonds have a maturity date — the date when the issuer returns your principal. If you hold the bond until maturity, you get your full principal back (assuming the issuer does not default). If you sell before maturity, you get whatever price the market will pay, which might be more or less than you paid.

Bond prices move in the opposite direction of interest rates. If interest rates rise after you buy a bond, the bond's price falls (because new bonds pay higher interest). If interest rates fall, the bond's price rises. If you need to sell before maturity and interest rates have risen, you will take a loss. If interest rates have fallen, you will make a gain.

Most municipal bond investors hold to maturity to avoid this price risk and to keep the tax-exempt interest payments coming. If you think you might need the money before the bond matures, consider a shorter-maturity bond (5 to 10 years) instead of a long-term bond (20 to 30 years), because shorter bonds are less sensitive to interest rate changes.

Municipal bond funds as an alternative to individual bonds

Instead of buying individual bonds, you can buy a municipal bond mutual fund or exchange-traded fund (ETF). These funds hold dozens or hundreds of municipal bonds and pay out the interest to you monthly or quarterly. The tax treatment is the same — the interest is tax-exempt if the bonds are tax-exempt.

Bond funds offer diversification (you own many bonds instead of a few) and professional management, but they charge annual fees (typically 0.2 to 0.5 percent per year for low-cost funds). You also do not get a maturity date — the fund holds bonds indefinitely and the share price fluctuates with interest rates. Bond funds are a good option if you want to invest a smaller amount or do not want to research individual bonds.

Individual bonds are better if you want to know exactly when you will get your money back, want to avoid ongoing fees, or want to hold a specific bond for its tax benefits. The choice depends on how much you are investing and how much time you want to spend managing the investment.

Frequently Asked Questions

Do I have to pay capital gains tax if I sell a municipal bond for more than I paid?

Yes. The interest is tax-exempt, but any profit you make from selling the bond at a higher price is subject to capital gains tax. If you hold the bond for more than one year before selling, it is taxed as a long-term capital gain (usually 15 or 20 percent). If you hold it for less than one year, it is taxed as a short-term capital gain (at your ordinary income tax rate).

What happens if a municipal bond issuer defaults?

If the issuer cannot pay the interest or principal, you lose that money. Some bonds are insured, which means an insurance company will pay you if the issuer defaults. Uninsured bonds carry this risk. Checking the bond's credit rating and the issuer's financial statements before buying helps you understand the default risk.

Can I buy municipal bonds in a retirement account like an IRA?

Yes, you can hold municipal bonds in an IRA, 401(k), or other retirement account. However, the tax exemption does not matter inside a retirement account, because the entire account is already tax-deferred or tax-free. You would be better off buying taxable bonds in the retirement account and municipal bonds in a regular taxable account.

How much should I invest in municipal bonds?

That depends on your overall financial plan, tax bracket, and risk tolerance. Municipal bonds are generally considered lower-risk investments, but they still carry credit risk and interest rate risk. A financial advisor can help you decide what percentage of your portfolio should be in bonds and what type of bonds fit your situation.

Can I buy municipal bonds from my state directly?

No. Even though the bonds are issued by your state or a city in your state, you must buy them through a broker. You cannot buy them directly from the government. Your broker handles the purchase and holds the bonds in your account.