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Tax-Exempt Bonds: What They Are, How They Work and How to Invest
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Tax-Exempt Bonds: What They Are, How They Work and How to Invest
Tax-exempt bonds pay interest that is exempt from either federal or state income taxes — and in some cases, both.
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9 years of experience Expertise Stocks ETFs economic newsSam Taube writes about investing for NerdWallet. He has covered investing and financial news since earning his economics degree from the University of Maryland in 2016. Sam has previously written for Investopedia, Benzinga, Seeking Alpha, Wealth Daily and Investment U, and has worked as an editor for Investment U, Wealth Daily and Haven Investment Letter. He is based in Brooklyn, New York.
Sam Taube writes about investing for NerdWallet. He has covered investing and financial news since earning his economics degree from the University of Maryland in 2016. Sam has previously written for Investopedia, Benzinga, Seeking Alpha, Wealth Daily and Investment U, and has worked as an editor for Investment U, Wealth Daily and Haven Investment Letter. He is based in Brooklyn, New York. Published in Lead Writer + more + more
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12 years of experience Expertise Brokerage accounts stock market cryptocurrencyChris Davis is a Managing Editor on the Investing team. He has passed the Series 65 (Uniform Investment Adviser Law Exam) and covered the stock market, investing strategies, investment accounts and cryptocurrency. His work has appeared in The Associated Press, The Washington Post, MSN, Yahoo Finance, MarketWatch, Newsday and TheStreet.
Chris Davis is a Managing Editor on the Investing team. He has passed the Series 65 (Uniform Investment Adviser Law Exam) and covered the stock market, investing strategies, investment accounts and cryptocurrency. His work has appeared in The Associated Press, The Washington Post, MSN, Yahoo Finance, MarketWatch, Newsday and TheStreet. Published in Managing Editor + more + moreIf you had an investment-related tax bill to pay from 2024, you may be inspired to explore tax-exempt investments moving forward. Below, we’re discussing a few types of bond investments whose interest payments are exempt from federal and/or state income tax, and are available in many brokerage accounts.
If you had an investment-related tax bill to pay from 2024, you may be inspired to explore tax-exempt investments moving forward. Below, we’re discussing a few types of bond investments whose interest payments are exempt from federal and/or state income tax , and are available in many brokerage accounts.Note that the tax exemptions below only apply to the income you would receive by holding bonds to maturity. If you sell a bond before maturity, for a higher price than you paid for it, your profit may still be subject to capital gains tax.
Note that the tax exemptions below only apply to the income you would receive by holding bonds to maturity. If you sell a bond before maturity, for a higher price than you paid for it, your profit may still be subject to capital gains tax .Municipal bonds
Municipal bondsStates, cities, counties and other local governments sometimes issue municipal bonds, or “munis,” to fund public projects such as school and bridge construction.
States, cities, counties and other local governments sometimes issue municipal bonds , or “munis,” to fund public projects such as school and bridge construction.Interest is exempt from: Federal income tax, and sometimes state income tax as well, depending on where you live and where the bond is from.
Interest is exempt from: Interest is exempt from: Federal income tax, and sometimes state income tax as well, depending on where you live and where the bond is from.Most states don’t tax their own muni bonds, and several have no state income tax at all. In those cases, muni bond interest is completely tax-free. District of Columbia residents also pay no local income taxes on any muni bonds, and all muni bonds from non-state U.S. territories such as Puerto Rico are state-tax-free in all states.
Most states don’t tax their own muni bonds, and several have no state income tax at all. In those cases, muni bond interest is completely tax-free. District of Columbia residents also pay no local income taxes on any muni bonds, and all muni bonds from non-state U.S. territories such as Puerto Rico are state-tax-free in all states.In some cases, however, interest payments on muni bonds that fund business-like enterprises such as stadiums and airports may be subject to the alternative minimum tax (AMT).
In some cases, however, interest payments on muni bonds that fund business-like enterprises such as stadiums and airports may be subject to the alternative minimum tax (AMT) .Risk level: Medium.
Risk level: Risk level: Medium.The yields on muni bonds are often higher than the yields on Treasury bonds. But that’s because, unlike the U.S. government, local governments do sometimes default on their debts. The city government of Detroit, for example, defaulted on more than $600 million worth of municipal bonds during its 2013 bankruptcy.
The yields on muni bonds are often higher than the yields on Treasury bonds. But that’s because, unlike the U.S. government, local governments do sometimes default on their debts. The city government of Detroit, for example, defaulted on more than $600 million worth of municipal bonds during its 2013 bankruptcy.Some muni bonds also have “call risk” (the issuing government may repay the principal of the bond ahead of schedule, causing investors to miss out on some interest payments). Plus, due to their high yields, muni bond prices may fall sharply in response to an increase in interest rates. That’s not an issue if you hold the bonds you buy to maturity, but it’s something to keep in mind.
Some muni bonds also have “call risk” (the issuing government may repay the principal of the bond ahead of schedule, causing investors to miss out on some interest payments). Plus, due to their high yields, muni bond prices may fall sharply in response to an increase in interest rates. That’s not an issue if you hold the bonds you buy to maturity, but it’s something to keep in mind.Available in: Certain brokerage accounts. Some accounts don’t offer individual bonds at all, and others only offer Treasury bonds and corporate bonds. Make sure you research a broker’s investment selections if you’re interested in buying individual muni bonds.
Available in: Available in: Certain brokerage accounts. Some accounts don’t offer individual bonds at all, and others only offer Treasury bonds and corporate bonds . Make sure you research a broker’s investment selections if you’re interested in buying individual muni bonds.Below is a list of the brokers reviewed by NerdWallet that offer individual muni bonds:
Below is a list of the brokers reviewed by NerdWallet that offer individual muni bonds: Ally Invest . Charles Schwab . E*TRADE . Fidelity . Firstrade . Interactive Brokers . J.P. Morgan Self-Directed . Merrill Edge . Vanguard . Zacks Trade .» See all these brokers compared on our list of the best brokers for bond investing.
» See all these brokers compared on our list of the best brokers for bond investing » See all these brokers compared on our list of the best brokers for bond investing .Tax-exempt bond funds
Tax-exempt bond fundsBuying individual muni bonds can be a hassle. One way to simplify the process of adding muni bonds to your portfolio is by investing in a tax-exempt bond fund. These typically invest in muni bonds, and may be available as mutual funds or exchange-traded funds (ETFs).
Buying individual muni bonds can be a hassle. One way to simplify the process of adding muni bonds to your portfolio is by investing in a tax-exempt bond fund. These typically invest in muni bonds, and may be available as mutual funds or exchange-traded funds (ETFs).There are even a few tax-exempt bond funds that invest in munis from a specific state, such as New York, thereby rendering their interest payments exempt from both federal and state taxes for residents of that state.
There are even a few tax-exempt bond funds that invest in munis from a specific state, such as New York, thereby rendering their interest payments exempt from both federal and state taxes for residents of that state.Interest is exempt from: Federal (and sometimes state) income tax… in theory. Some tax-exempt bond funds advertise themselves as “AMT-free” as well, meaning that they avoid muni bonds that may generate AMT liability.
Interest is exempt from: Interest is exempt from: Federal (and sometimes state) income tax… in theory. Some tax-exempt bond funds advertise themselves as “AMT-free” as well, meaning that they avoid muni bonds that may generate AMT liability.However, fund managers have a significant amount of discretion over what they invest in, and some tax-exempt bond funds disclaim that they may occasionally invest in assets that do have federal income tax or AMT liability. Make sure you read the fine print before investing.
However, fund managers have a significant amount of discretion over what they invest in, and some tax-exempt bond funds disclaim that they may occasionally invest in assets that do have federal income tax or AMT liability. Make sure you read the fine print before investing.Risk level: Medium-low.
Risk level: Risk level: Medium-low.Funds containing muni bonds deal with the same risks as investors holding individual muni bonds, but a bond fund reduces these risks somewhat for its shareholders by diversifying its investments across many muni bonds.
Funds containing muni bonds deal with the same risks as investors holding individual muni bonds, but a bond fund reduces these risks somewhat for its shareholders by diversifying its investments across many muni bonds.Available in: Almost all brokerage accounts. Some brokerage accounts don’t offer mutual funds, but tax-exempt bond ETFs can be found wherever ETFs are sold (i.e., in just about any brokerage account).
Available in: Available in: Almost all brokerage accounts. Some brokerage accounts don’t offer mutual mutual funds, but tax-exempt bond ETFs can be found wherever ETFs are sold (i.e., in just about any brokerage account).Treasury bonds, bills and notes
Treasury bonds, bills and notesThe U.S. government borrows money by issuing Treasury securities of various durations. The term “Treasury bond” is sometimes used to refer specifically to bonds with durations of 20 years or more. Treasury securities with durations of 2 to 10 years are called “notes,” while shorter-duration securities are called “bills.”
The U.S. government borrows money by issuing Treasury securities of various durations. The term “Treasury bond” is sometimes used to refer specifically to bonds with durations of 20 years or more. Treasury securities with durations of 2 to 10 years are called “notes,” while shorter-duration securities are called “bills.”Interest is exempt from: State income tax, but not federal income tax.
Interest is exempt from: Interest is exempt from: State income tax, but not federal income tax .Risk level: Very low.
Risk level: Risk level: Very low.The U.S. government is one of the most credible borrowers in the world. It’s not impossible that some cataclysm could cause it to miss payments on Treasuries at some point in the future, but that is so unlikely that it’s generally not worth worrying about.
The U.S. government is one of the most credible borrowers in the world. It’s not impossible impossible that some cataclysm could cause it to miss payments on Treasuries at some point in the future, but that is so unlikely that it’s generally not worth worrying about.In recent years, the U.S. government has sometimes had its credit rating downgraded by independent rating agencies, and there have been frequent political fights in Washington over keeping the government funded and raising the debt ceiling. But none of these things have led to a default yet, and the odds of one happening any time in the foreseeable future are still low.
In recent years, the U.S. government has sometimes had its credit rating downgraded by independent rating agencies, and there have been frequent political fights in Washington over keeping the government funded and raising the debt ceiling. But none of these things have led to a default yet, and the odds of one happening any time in the foreseeable future are still low.Available in: Most brokerage accounts. Any account that offers individual bonds will offer Treasuries. There is also an emerging product called a Treasury account, which automatically invests — and re-invests — in T-bills. (NerdWallet has a partnership with Atomic Treasury to offer a Treasury account. Public, an online broker we review, also offers a Treasury account.)
Available in: Available in: Most brokerage accounts. Any account that offers individual bonds will offer Treasuries. There is also an emerging product called a Treasury account, which automatically invests — and re-invests — in T-bills. (NerdWallet has a partnership with Atomic Treasury to offer a Treasury account. Public , an online broker we review, also offers a Treasury account.) About the author Sam Taube Sam Taube Sam Taube writes about investing for NerdWallet. He has covered investing and financial news since earning his economics degree in 2016. See full bio.Helpful resources
Helpful resources What Are Bonds? Types, How They Work Bonds vs. Stocks: A Beginner’s Guide Municipal Bonds: Basics, Pros and Cons and How to Invest What Are Treasurys? Government Bonds vs. Notes vs. Bills More like this Investment Basics Investing Bonds Best IRA Accounts for 2026 After hours of analysis, we found that the best IRA accounts offer a large selection of low-cost mutual funds and ETFs, helpful retirement planning tools, educational guidance and strong customer support. Alana Benson What Is a Brokerage Account? Where and How to Open One Opening a brokerage account is the first step to investing. You can open one in as little as 15 minutes, but you'll need to fund it and select investments to start building out your portfolio. 2 By Arielle O'Shea, Pamela de la Fuente Best Robo-Advisors: Top Picks for 2026 We spent hours testing robo-advisors to find ones that charge low fees but still offer high-quality features, including automated portfolio rebalancing, exposure to a range of asset classes and financial planning tools. 2 By Alana Benson, Sabrina Parys