What Are the Best States for Municipal Bonds?

Municipal bonds are debt securities issued by states, counties, and other governmental entities to fund public projects like schools and hospitals. When an investor purchases a municipal bond, they are lending money to a government entity. In return, the issuer promises to repay the principal on a specified maturity date and make periodic interest payments. This financing method allows public works to proceed without immediate full funding from the government’s operating budget, providing a predictable income stream for investors.

The Core Tax Advantage of Municipal Bonds

The main appeal of municipal bonds is their tax treatment. The interest income is exempt from federal income tax, but there are exceptions. Interest from certain “private activity bonds,” which finance projects for private entities, can be subject to the Alternative Minimum Tax (AMT). Additionally, if a bond is bought on the secondary market at a discount, the gain at maturity may be taxed as ordinary income.

For retirees, it’s important to know how this tax-exempt interest affects Social Security. The IRS includes this interest when calculating Modified Adjusted Gross Income (MAGI), which determines if Social Security benefits are taxable. As a result, holding municipal bonds can indirectly cause a portion of Social Security income to become taxable.

The tax benefit can extend to state and local levels. If an investor buys a municipal bond issued by their state of residence, the income is often exempt from state and local taxes, creating a “triple-tax-free” investment. A few states, however, tax their own bonds, while others exempt interest from any municipal bond, regardless of origin. Any capital gains from selling a bond at a profit before it matures are taxable.

Identifying States with High Tax Burdens

For investors in states with high personal income tax rates, the appeal of in-state municipal bonds is strong. The state-level tax exemption becomes more valuable as an individual’s state tax liability increases. Purchasing bonds issued within one’s own high-tax state can provide a financial advantage by shielding investment income from both federal and state taxes.

To compare the return of a tax-exempt municipal bond with a taxable one, investors use a calculation called the tax-equivalent yield (TEY). This formula determines what a taxable bond would need to yield to equal the return of a tax-free bond after taxes are accounted for. The formula is: Tax-Equivalent Yield = Tax-Exempt Yield / (1 – Marginal Tax Rate). An investor’s marginal tax rate, which includes federal and state rates, is a component of this calculation. For example, an investor in the 32% federal tax bracket who also faces a 9% state tax rate has a combined marginal rate of 41%. If this investor considers an in-state municipal bond with a 4% tax-free yield, the TEY is 6.78%, meaning a taxable investment needs that return to match the municipal bond.

The Case for States with No Income Tax

States with no personal income tax, such as Florida or Texas, present a different opportunity. For residents of these states, there is no state-level tax benefit to be gained by purchasing in-state bonds. This lack of a state tax shield encourages these investors to look nationally for the best available yields and credit quality. This allows them to build a geographically diversified portfolio based on where they can find the most attractive risk-adjusted returns.

Furthermore, bonds issued by no-income-tax states can be attractive to a nationwide pool of investors. These states often must maintain competitive fiscal policies and strong economies to attract capital, which can translate into high credit ratings for their bonds. As a result, investors from any state seeking capital preservation and low default risk may find bonds from no-tax states appealing.

Evaluating Credit Quality

Assessing a municipal bond’s credit quality is an important step, regardless of the state’s tax laws. Credit rating agencies like Moody’s, S&P Global Ratings, and Fitch Ratings provide independent assessments of an issuer’s ability to meet its debt obligations. These ratings help investors gauge a bond’s risk of default.

The rating scales are letter-based. S&P and Fitch use a scale from ‘AAA’ (highest quality) to ‘D’ (default), while Moody’s uses ‘Aaa’ to ‘C’. Bonds rated ‘BBB-‘ (S&P/Fitch) or ‘Baa3’ (Moody’s) or higher are considered “investment-grade,” signifying lower default risk. Ratings below this threshold are “speculative” or “high-yield.”

The type of bond also defines the source of repayment. General Obligation (GO) bonds are backed by the full faith and credit of the issuing government, including its taxing power. In contrast, Revenue bonds are backed only by revenues from a specific project, like a toll road. Historically, GO bonds are considered more secure because of the issuer’s taxing power, but revenue bonds tied to essential services can also have strong creditworthiness.