Tax-exempt interest from municipal bonds is free from regular federal income tax and, in the case of state-specific municipal bonds, the interest may be exempt from regular state income tax as well. Tax-exempt interest also escapes the 3.8% surtax on investment income. The general rule is that the benefit of tax-exempt interest increases along with an investor’s income and marginal tax rate. The marginal tax rate is the percentage taxed on additional income. For example, the highest marginal federal income tax rate for 2016 is 39.6%, which begins on income over $415,051 (single filing) or $466,950 (joint filing).
One caveat to note is that, similar to taxable-bond interest, municipal bond interest can also impact social security benefits because tax-exempt interest must be considered as income when determining what portion (if any) of social security benefits are subject to taxes. However, the tax advantages of municipal bond income may far outweigh that impact for those with significant income outside of social security benefits.