Bonds course · Lesson 7 of 7
A municipal bond wins only above a certain tax rate.
States and cities borrow with municipal bonds. The interest is usually free of federal tax, so the yield is lower. Whether that is a good trade depends on your tax rate.
The tax benefit
The interest on municipal bonds is generally exempt from federal income tax. It can also be exempt from state and local tax if you live in the state that issued the bond. Some municipal bonds can be subject to the alternative minimum tax.
The tax-equivalent yield
To compare a municipal bond with a taxable bond, divide the municipal yield by one minus your tax rate. The result is the taxable yield that gives you the same income after tax.
The example compares a municipal bond at 3.2% with a taxable bond of similar quality and term at 4.5%. The two are equal at a tax rate of 28.9%.
| 2026 bracket, married, joint return | Taxable income over | Tax-equivalent yield | Beats 4.5%? |
|---|---|---|---|
| 10% | $0 | 3.56% | No |
| 12% | $24,800 | 3.64% | No |
| 22% | $100,800 | 4.10% | No |
| 24% | $211,400 | 4.21% | No |
| 32% | $403,550 | 4.71% | Yes |
| 35% | $512,450 | 4.92% | Yes |
| 37% | $768,700 | 5.08% | Yes |
In this example, the municipal bond wins from the 32% bracket, which starts at $403,550 of taxable income. Below that, the taxable bond pays more after tax.
Two more taxes
Above $250,000 of modified AGI for a married couple, taxable interest can also pay the 3.8% net investment income tax. In the 32% bracket with that tax, the municipal bond equals 4.98%.
State tax helps too. A resident who buys a bond from the home state, in the 24% bracket with a 5% state tax, gets a tax-equivalent yield of 4.51%. This simple calculation ignores any federal deduction for state tax.
Where not to hold them
Do not hold municipal bonds in an IRA or a 401(k). Those accounts already avoid tax on interest, so you would accept a lower yield for no benefit.
Key points
- Divide the municipal yield by one minus your tax rate to compare it with a taxable bond.
- Municipal bonds usually win only in the higher brackets.
- Keep municipal bonds in a taxable account, not in an IRA or a 401(k).
Sources
- Investor.gov, Municipal Bonds, for the tax treatment of municipal bond interest, and for prices that fall when rates rise.
- IRS, IR-2025-103, Tax Inflation Adjustments for Tax Year 2026, for the 2026 brackets of a married couple with a joint return.
- IRS, Net Investment Income Tax, for the 3.8% tax and the $250,000 threshold.