Both state and local government entities issue municipal bonds, and the interest is generally exempt from federal income tax. This is done because the funds from the bond issue will be used to fund necessary government services or infrastructure projects. In addition the agencies issuing the bonds are given lower interest rates when they invest in public services and projects. In most states, if you buy municipal bonds, the interest income you earn will also be exempt from state taxes. If you live in a metropolitan area with a local income tax and you invest in bonds issued by a local government agency, that interest income will be tax-free on the local, state, and federal level. Categories of municipal bonds include the following: ◠Revenue bonds – project revenues, such as parking fees, are used for principal and interest payments. ◠General obligation bonds – These are backed by the issuing agency, and they entail less risk because they are linked to the tax base, rather than some source of revenue. Other characteristics of municipal bonds Today, many governmental agencies insure their bonds as a guarantee that the principal will be repaid. In this case, the issuer feels that purchasing insurance is less costly than paying an interest rate that is based on their credit rating. When investors buy AAA municipal bonds that are insured, the risk they assume is minimal. Similar to corporate bonds, municipal bonds also have credit ratings, and certain municipal issues will pay a higher interest rate when there is additional risk. For example, if a revenue bond is used to finance a parking garage and the projected revenue fails to meet expectation, the bondholder will be at risk. Usually, a revenue bond will have a reserve fund, which allows the issue to cope with a temporary revenue shortfall. If you are subject to a federal or state alternative minimum tax (AMT), the interest income earned from municipal bonds that are categorized as “non-qualified private activity bonds†may entail payment of the AMT, and this would not be a wise investment in your case.