Tax-Exempt Bonds

Tax-exempt bonds are debt securities—usually municipal bonds—issued by state and local governments or certain qualifying private entities, where the interest income paid to investors is exempt from federal income tax and sometimes state or local taxes as well. Because investors don’t pay tax on the interest, these bonds typically offer lower interest rates than taxable bonds, but can result in higher after-tax returns, especially for those in higher tax brackets. Most tax-exempt bonds are used to fund public projects like schools, roads, and hospitals and are considered low- to medium-risk investments. Interest on these bonds is only tax-free when held to maturity; if sold for a profit before maturity, that gain may be taxable.