Investing Assets & Markets Mutual Funds Taxation of Municipal Bond Funds What Are Municipal Bond Funds and How Are They Taxed? By Kent Thune Kent Thune Twitter Kent Thune has spent more than two decades in the financial services industry and owns Atlantic Capital Investments, an investment advisory firm, in Hilton Head Island, South Carolina. He's written hundreds of articles for a range of outlets, including The Balance, Kiplinger, Marketwatch, and The Motley Fool. learn about our editorial policies Updated on May 22, 2022 Reviewed by Chip Stapleton Reviewed by Chip Stapleton Chip Stapleton is a Series 7 and Series 66 license holder, passed the CFA Level 1 exam, and is a CFA Level 2 candidate. He, and holds a life, accident, and health insurance license in Indiana. He has eights years' experience in finance, from financial planning and wealth management to corporate finance and FP&A. learn about our financial review board In This Article View All In This Article What Are Municipal Bond Funds? How Are Municipal Bond Funds Taxed? Who Should Invest in Municipal Bond Funds? Photo: Brad McGinley Photography / Getty Images Municipal bonds are debt securities that a city, county, or state issues to raise funds for a project that will do good for a community. Such projects often include upgrades to water and sewer systems, roads, and public buildings. Municipal bonds can be taxable or tax-exempt. The latter are much more common. It can be smart to add these assets to a taxable portfolio because a portion or all of the income they generate can be exempt from taxes. Here's what you need to know about municipal bonds, how they're taxed, and how they compare to corporate bonds. Key Takeaways Municipal bond funds are mutual funds made up of municipal bonds, which are debt instruments issued by a government entity.The earnings from municipal bonds are often exempt from federal (and sometimes also state or local) taxes.Municipal bond fund yields may be lower compared to those of other, corporate bonds. This decreased yield can be offset by the tax savings.The tax-equivalent yield is the pre-tax yield a taxable bond must pay to equal the tax-free municipal bond yield. What Are Municipal Bond Funds? In general, a bond is a debt obligation. You're lending money to an entity, which promises to pay it back with interest. These may be corporations or government bodies. Municipal bonds, which are also called "munis," are a subset of bonds issued by government municipalities or their agencies. Note If you buy a government bond in the United States that's not from the federal Treasury Department, it's likely to be some form of municipal bond. It could come from a state government, a city, a county, or a public utility. These debt obligations are used to raise money to fund local projects. They help build schools, parks, and highways, for example. Municipal bond funds are mutual funds that invest mostly in municipal bonds. How Are Municipal Bond Funds Taxed? Municipal bond funds provide investors with interest that is exempt from federal income taxes. This income may also be exempt from state and local taxes if you reside in the issuing state or town. For instance, a New York City bond could be triple-tax-free. That means it could be exempt from federal, state, and local taxes if the investor lives and pays taxes in New York City. For this reason, municipal bond funds are often referred to as "tax-free" or "tax-exempt" investments. Who Should Invest in Municipal Bond Funds? Investors who should use municipal bond funds are mostly those who want to earn yields that are typically higher than those of money market funds. The tax-free income opportunities could be extra-attractive to those who may be in a high tax bracket and want to reduce their tax burden. Note The yields on municipal bonds are often lower compared to other bonds, such as those issued by corporations. They may also be higher than those of comparable federal Treasury bonds. Even when compared to higher-yielding corporate bonds, the tax benefits of municipal bonds can sometimes make up for the lower yields. Determining Tax-Equivalent Yields One way to help decide if a municipal bond fund is the right investment for you is known as the "tax-equivalent yield." For instance, a taxable bond, such as a corporate bond that pays 5%, may at first seem more attractive to an investor who also has the option to buy a tax-free municipal bond that pays 4%. To more accurately tell which bond is best, the investor can calculate the tax-equivalent yield. The tax-equivalent yield is the pre-tax yield the taxable bond must pay to equal the tax-free municipal bond yield. The calculation is the tax-free municipal bond yield divided by one, minus the investor's tax rate. Here's the calculation for an investor in the 35% marginal tax bracket, if the municipal bond is paying 4%: Tax-Equivalent Yield = .04 / (1 - .35) = 0.615, or 6.15% This calculation reveals that the income tax savings of investing in the tax-free municipal bond are equivalent to a taxable bond earning 6.15%. If the taxable bond doesn't offer at least a 6.15% yield, then the municipal bond is likely a better deal for those seeking the most income. Returning to the example scenario of choosing between a 4% muni bond and a 5% corporate bond, the bond investor may be wise to choose the tax-free municipal bond instead of the taxable corporate bond. The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Office of Investor Education and Advocacy. "Municipal Bonds." Office of the New York City Comptroller. "Buy NYC Bonds."