Muni bonds are exempt from federal tax to most individual investors, but they are subject to state and local taxation. Since everyone's federal bracket is higher - your yield is most helped by being federally exempt. If you buy a bond issued in your home state, you may be exempt to all 3 forms of ordinary income taxation.

Tax Free Yield

If an investor is in a high bracket - they can gain a higher tax free rate or return or yield. If you buy a muni bond at 5% stated YTM and you are in the 28% bracket, we can calculate the tax free yield like this: 5 divided by 72 (100- tax bracket), which equals 6.94%. An investor who is looking at other taxable investments would need to consider that the municipal bond, in this case - is equal to 6.94% in a taxable investment.

Ordinary Income

The free taxation with municipal securities only applies to the interest earned on the bond. This is the ordinary income portion of the investment. Whether someone should buy a muni bond rests heavily on the tax bracket of the person and whether they can buy a suitable bond in their home state.

Capital Gains

When an investment is sold above it's cost, it is subject to a capital gains tax. This is no different with municipal bonds and notes. The fact that they have a taxation advantage does not apply to a bond being sold. These are two different forms of income.

See also: Closed End Muni Fund

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