Municipal bond interest generally is exempt from federal income tax but you may be subject to state and local income tax. For example, an investor living in Maryland who buys a municipal bond issued in Virginia would owe income tax to Maryland, on his interest from the Virginia bond.
In many cases, paying one tax will reduce another. Say you live in a state where your income tax rate is 10 percent and you are in a 28 percent federal tax bracket.
Suppose you invest $10,000 in an out-of-state muni, receive $400 (4 percent) in interest, and pay $40 (10 percent of the interest income) tax to your home state. You can take that $40 state tax payment as a deduction on your federal tax return and save around $11, in a 28 percent tax bracket. Your net tax would be $29, or 7.25 percent.
Many taxpayers, especially those in high-tax states, pay the alternative minimum tax (AMT) instead of regular income tax. If you pay the AMT, state taxes are not deductible.
In this example, if you are paying the AMT you would effectively pay the full 10 percent state tax on your “tax-exempt” bond, not 7.25 percent. Thus you should consider buying municipal bonds issued in your home state because the interest typically will be exempt from federal, state, and local income taxes.