Municipal bonds (often referred to as “munis”) can be attractive to income-seeking investors because they provide an income stream exempt from federal and, in certain cases, state and local income taxes. Like other fixed-income investments, munis involve risk. But as part of a broadly diversified portfolio, they can offer you an effective way to increase your after-tax earnings.

State and Local Projects

Munis are debt securities issued by state and local governments — or entities on their behalf — to generate funds for various public needs. Examples include toll roads, schools and hospitals, as well as general use bonds of cities, counties and states.

For investors, the main selling point of m3.8nis is that their income is exempt from federal income taxes. What’s more, if you live in the state in which the bonds are issued — or if you buy bonds issued by U.S. territories, such as Puerto Rico or Guam — the securities’ interest payments may also be exempt from state and local taxes. One federal exception is that not all municipal bond income is exempt from the alternative minimum tax.

Benefits For Investors

Munis may be appropriate for investors looking to manage their tax exposure and traditionally have been of greatest use for upper-income taxpayers. In general, the higher your combined federal, state and local income tax rate, the more valuable munis become.

Consider that the top federal income tax rate is 37% (as of 2023) and high-net-worth individuals face an additional 3.8% Medicare tax on net investment income. The bite is even greater for residents of high-tax states. In California, for example, the top state tax bracket is currently 13.3%, meaning that, for every dollar earned over $1 million, you’d potentially face a combined income tax rate of more than 54%.

Consider the Risks

As with any fixed-income product, munis are vulnerable to rising interest rates. They also face credit risk — the threat that a bond issuer won’t be able to repay its debts. In fact, even the idea of a default can cause bond prices to drop — for example, when a major credit agency downgrades a city’s bonds because the city (not the specific project) is having financial problems.

Although credit risk is a real challenge — especially when dealing with lower-rated municipal bonds — it’s worth noting that munis have historically defaulted much less than comparable corporate bonds. This doesn’t mean that corporate bonds are a worse investment. Many corporate bonds offer higher yields as compensation for the increased default potential and higher taxes. But it does suggest that the credit challenges faced by a few states and municipalities in the last decade or so aren’t necessarily representative of the risks involved with tax-exempt debt.

Individual Bonds Vs. Mutual Funds Even though you can buy individual bonds directly from municipal issuers, most investors find it more efficient to gain exposure to this asset class through mutual funds. The latter provide a few significant advantages: They’re more liquid and generally provide better diversification than most investors can achieve on their own buying individual bonds.