Municipal bonds are bought through a brokerage account, not directly from the government

You cannot walk into a municipal office and buy a bond. Instead, you open an account with a brokerage firm — either a full-service broker like Fidelity or Schwab, or an online discount broker — and purchase bonds through their platform the same way you would buy stocks. The bond issuer (a city, county, or state) has already sold the bonds to underwriters, who then sell them to brokers, who sell them to you. You pay the asking price plus any markup the broker adds.

The tax-free part is automatic: if you hold a municipal bond issued in your state and you live in that state, the interest you earn is exempt from federal income tax and usually from state income tax too. You do not have to file anything special or prove anything to the IRS. The bond simply pays you interest that does not get reported on your 1040.

Out-of-state municipal bonds are still exempt from federal tax, but you will owe state income tax on the interest if you live in a state that taxes it. A California resident buying a New York bond pays federal tax on the interest but not state tax. A New York resident buying the same bond pays neither.

Key Takeaways

  • You buy municipal bonds through a brokerage account, and the tax exemption is built into the bond itself — you do not have to do anything to claim it.
  • In-state municipal bonds are exempt from both federal and state income tax; out-of-state bonds are exempt from federal tax only.
  • The interest rate on a municipal bond is lower than a taxable bond because of the tax break, so compare the after-tax yield, not the stated rate.
  • You can buy individual bonds and hold them to maturity, or buy a municipal bond fund or ETF for instant diversification.
  • Brokerage fees, markups, and fund expense ratios all reduce your return, so compare costs before you buy.

Opening a brokerage account and finding bonds to buy

Start by opening an account at a brokerage. Fidelity, Charles Schwab, E*TRADE, and Vanguard all offer municipal bond trading. Online brokers like Merrill Edge and TD Ameritrade do as well. You will need to provide your Social Security number, proof of address, and bank account information for deposits and withdrawals. The process takes 10 to 15 minutes online.

Once your account is open, log in and search for municipal bonds. Most brokers have a bond screener where you can filter by state, maturity date, credit rating, and yield. If you want bonds from your home state only, select that filter. If you are willing to buy out-of-state bonds, leave it open. You can also search by issuer name — for example, "New York City Housing Authority" or "California Water Service".

The bond listing will show the coupon (the interest rate), the maturity date, the current price, and the yield to maturity (YTM). The YTM is what matters: it accounts for the price you pay today and the interest you will receive over the life of the bond. A bond trading at a discount (below par value) will have a higher YTM than its coupon rate. A bond trading at a premium will have a lower YTM.

Comparing the after-tax yield to taxable alternatives

A municipal bond pays less interest than a taxable bond because you do not pay income tax on it. To decide whether a municipal bond is worth buying, calculate what a taxable bond would need to pay you to match the municipal bond's after-tax return.

The formula is simple: divide the municipal bond's yield by (1 minus your tax bracket). If you are in the 24% federal tax bracket and a municipal bond yields 3%, the taxable equivalent yield is 3% ÷ (1 − 0.24) = 3% ÷ 0.76 = 3.95%. That means a taxable bond would have to pay you 3.95% to give you the same after-tax income. If taxable bonds are only yielding 3.5%, the municipal bond is the better deal.

Your tax bracket depends on your income. For 2024, the federal tax brackets range from 10% to 37%. You can find your bracket on your most recent tax return or on the IRS website. If you live in a state with income tax and you are buying an in-state municipal bond, add your state tax rate to your federal rate. A resident of New York in the 24% federal bracket and the 6.85% state bracket would use a combined rate of 30.85%.

Municipal bonds make the most sense if you are in a high tax bracket — typically 32% or higher. If you are in the 12% bracket, a taxable bond or a money market fund might give you better returns after tax.

Individual bonds versus bond funds and ETFs

You have two paths: buy individual municipal bonds and hold them to maturity, or buy a municipal bond fund or exchange-traded fund (ETF) that holds many bonds.

Individual bonds give you certainty about your cash flow. You know exactly when you will receive each interest payment and when you will get your principal back. If you hold the bond to maturity, you do not have to worry about price fluctuations. The downside is that you need money to buy a bond — most brokers require a minimum purchase of $5,000 to $25,000 per bond — and you own only one issuer's debt. If that issuer runs into trouble, you lose.

Municipal bond funds and ETFs pool money from many investors and buy dozens or hundreds of bonds. You can start with as little as $100 or $1,000, depending on the fund. You own a tiny piece of many issuers, so one issuer's problems do not sink your investment. The downside is that the fund's value changes daily based on interest rate movements, and you pay an annual expense ratio (usually 0.2% to 0.5% per year for a low-cost fund, higher for actively managed funds). If you sell before maturity, you might get less than you paid.

For most people, a municipal bond ETF or index fund is simpler and cheaper than buying individual bonds. Vanguard's Tax-Exempt Bond ETF (VTEB) and iShares National Muni Bond ETF (MUB) are widely held and charge low fees. If you want state-specific tax breaks, look for a state-specific fund — for example, Vanguard's California Tax-Exempt Bond ETF (VCIT) for California residents.

Understanding costs and how they reduce your return

When you buy an individual municipal bond through a broker, you pay the asking price plus a markup. The markup is not always shown as a separate line item; it is built into the price. A broker might quote you a bond at 101.50 (meaning 101.5% of par value), but the actual market price might be 101.25. The difference — 0.25 points, or $2.50 per $1,000 bond — is the broker's profit.

Markups on municipal bonds typically range from 0.5 to 2 points, depending on the bond's size and liquidity. Smaller, less-traded bonds have larger markups. You can shop around: call or email multiple brokers and ask for a quote on the same bond. The prices will vary.

Municipal bond funds and ETFs charge an annual expense ratio. A fund charging 0.20% per year costs $20 per $10,000 invested. Over 20 years, that compounds. A fund charging 0.50% costs $50 per $10,000 per year. Actively managed funds often charge 0.50% to 1.0% or more. Index funds and ETFs are cheaper because they simply track a benchmark rather than trying to beat it.

Some brokers also charge a transaction fee to buy or sell a bond — typically $10 to $50 per trade. Discount brokers often waive these fees. Ask before you open an account.

Credit quality and the risk of default

A municipal bond is only as good as the issuer's ability to pay. A city or county in financial trouble might default — fail to pay interest or principal on time. To assess risk, look at the bond's credit rating.

The three major rating agencies are Moody's, Standard & Poor's, and Fitch. They assign ratings from AAA (safest) down to C or D (highest risk of default). Most municipal bonds are rated A or higher. A bond rated BBB or lower is considered "junk" and carries real default risk. Most individual investors should stick to A-rated bonds or better.

You can find a bond's rating on the broker's website or on the Municipal Securities Rulemaking Board (MSRB) website, which is free and public. Search for the bond's CUSIP number (a unique identifier) and you will see the rating, the issuer's financial statements, and any news about the bond.

Municipal bond funds disclose their average credit quality. A fund holding mostly AAA and AA bonds is safer than one holding BBB and lower. The trade-off is that lower-rated bonds pay higher interest to compensate for the risk.

Tax reporting and what happens at maturity

Municipal bond interest does not appear on your 1040 as taxable income, but it does appear on Schedule B if you have more than $1,500 in interest income from any source. You report it as tax-exempt interest. The IRS tracks it to make sure you are not claiming it as a deduction (you cannot deduct interest you did not pay tax on).

If you sell a municipal bond before maturity and make a profit, that profit is taxable as a capital gain. If you sell at a loss, you can deduct the loss. Your broker will send you a 1099-B form showing your sales and gains or losses. This applies to individual bonds and to fund shares.

When a bond matures, the issuer pays you the principal (usually $1,000 per bond). Your broker deposits it into your account. You can then reinvest it in another bond or fund, or withdraw it.

Frequently Asked Questions

Do I have to buy bonds from my home state to get the tax break?

No. Any municipal bond is exempt from federal income tax. But if you buy a bond from another state, you will owe state income tax on the interest if your state taxes it. In-state bonds are exempt from both federal and state tax, which is why they are more valuable to residents of high-tax states.

What is the minimum amount I need to invest?

Individual bonds typically require $5,000 to $25,000 per bond, depending on the broker. Municipal bond funds and ETFs can be bought for as little as $100 to $1,000, depending on the fund. ETFs trade like stocks, so you can buy a single share.

Can I lose money on a municipal bond?

If you hold an individual bond to maturity and the issuer does not default, you get your full principal back. But if you sell before maturity, the price may have fallen if interest rates rose. With a fund or ETF, the value changes daily. You can also lose money if the issuer defaults, though this is rare for investment-grade bonds.

Are municipal bonds a good investment right now?

That depends on current interest rates, your tax bracket, and what other investments are available. Compare the after-tax yield of a municipal bond to the yield of a taxable bond or a money market fund. If the municipal bond's after-tax return is higher, it is worth considering. Your tax bracket matters most: they are most valuable to high-income earners.

How do I know if a municipal bond is safe?

Check the credit rating on the MSRB website or your broker's platform. Bonds rated A or higher are generally considered safe. Read the issuer's financial statements and any news about the bond. If the issuer is in financial distress, the bond will trade at a discount and pay higher interest to compensate for the risk.