Tax-Exempt Bonds Explained: Yields, AMT, and Medicare Impact

Tax-exempt bonds are debt securities, mostly issued by state and local governments, whose interest payments are excluded from federal income tax under Internal Revenue Code Section 103.¹ They’re commonly called municipal bonds, or munis. The exemption is real, but it isn’t total: capital gains on sale are fully taxable, some categories trigger the Alternative Minimum Tax, and the interest can quietly raise Medicare premiums and make Social Security benefits taxable even though it isn’t taxed itself.

How the Federal Exemption Works

Under Section 103, interest on state and local bonds is excluded from your gross income for federal tax purposes.¹ The coupon payments you receive simply aren’t added to your taxable income the way corporate or Treasury interest would be.

The exclusion functions as a built-in subsidy. Because buyers don’t owe federal tax on the interest, issuers can offer lower coupons and still attract capital, and the savings flow into cheaper financing for schools, water systems, highways, and similar projects. Most munis pay a fixed coupon twice a year, with maturities from one to 30 years.²

Three categories fall outside the exemption: private activity bonds that don’t meet the “qualified bond” requirements, arbitrage bonds, and bonds that fail certain registration rules.¹ Those are covered further down.

Comparing Yields With the Tax-Equivalent Calculation

A 4% muni yield and a 4% corporate yield aren’t the same thing once tax is applied. To compare fairly, divide the muni’s yield by one minus your marginal federal tax rate. The result is the tax-equivalent yield: what a taxable bond would need to pay to match the muni after federal tax.

Say you’re in the 24% federal bracket and considering a muni yielding 3.5%. Divide 3.5% by (1 − 0.24), and you get 4.61%. A taxable bond would need to pay at least 4.61% to leave you with the same after-tax income. For someone in the 37% bracket, that same 3.5% muni has a tax-equivalent yield of about 5.56%. The higher your bracket, the more the exemption is worth, which is why munis are most popular among top-bracket investors.

If your state also exempts the interest, use your combined federal-and-state marginal rate in the formula. That pushes the tax-equivalent yield higher still, and it’s why residents of high-tax states often find munis attractive at coupon rates that look mediocre on their face.

State, Local, and Territory Treatment

The federal exemption is only half the picture. Whether you also avoid state and local income tax depends on where you live and who issued the bond. Many states exempt interest on bonds issued within their own borders. If your city does the same for locally issued bonds, you get “triple tax-exempt” income: free of federal, state, and local tax. Buy a bond from another state, and your home state will generally tax the interest like any other investment income.

Territory bonds get their own treatment. Under federal law, interest on bonds issued by the government of Puerto Rico is exempt from state and local tax regardless of where the bondholder lives.³ Guam, the U.S. Virgin Islands, and American Samoa have similar provisions, which is why territory bonds have historically drawn buyers nationwide.

What Still Gets Taxed

The exemption covers interest income. It doesn’t cover profits from selling the bond. Sell a muni for more than you paid, and the difference is a taxable capital gain, no different from selling stock at a profit.⁴ For 2026, long-term capital gains (held more than a year) are taxed at 0%, 15%, or 20% depending on income. Short-term gains are taxed at your ordinary rate.

Market Discount Bonds

Buying a muni on the secondary market below face value creates a wrinkle. The IRS applies a de minimis test: multiply 0.25% of face value by the number of full years to maturity. If your discount is below that threshold, appreciation at sale or redemption is a capital gain. If it exceeds the threshold, the appreciation is taxed as ordinary income, which is a much steeper rate for most investors.⁵

On a $1,000 face bond with 10 full years left, the threshold is $25 (0.25% × $1,000 × 10). Pay $980 (a $20 discount), and any gain is a capital gain. Pay $950 (a $50 discount), and the $50 must be reported as ordinary income at maturity.

Original Issue Discount

Some munis are issued below face value from the start. Unlike taxable OID instruments, you don’t include the accrued discount in income year by year. Instead, you add the accrued OID to your cost basis, which reduces any gain or increases any loss when you sell or redeem.⁶

Wash Sale Rule

The wash sale rule applies to munis. Sell one at a loss and buy a substantially identical bond within 30 days on either side, and you can’t deduct the loss.⁷ Losses on munis are otherwise deductible as capital losses, so the rule matters if you’re harvesting losses inside a muni portfolio. Bonds from different issuers, with different coupons, or different maturities are generally not “substantially identical,” which gives you room to reinvest in a similar but distinct bond.

The Retiree Trap: Medicare and Social Security

This is where the exemption often disappoints. Muni interest doesn’t land on taxable income, but the IRS and Social Security Administration still count it for two income-based thresholds.

Medicare Premium Surcharges

The Social Security Administration sets your Medicare Part B and Part D premiums using modified adjusted gross income, which is your AGI plus the tax-exempt interest from Line 2a of Form 1040.⁸ For 2026, single filers above $109,000 in MAGI and joint filers above $218,000 pay income-related monthly adjustment amounts on top of the standard premium.⁹ The standard Part B premium for 2026 is $202.90 per month; at the highest IRMAA tier the premium reaches $689.90, more than triple. A large muni portfolio can push a retiree into a higher tier on its own.

Taxation of Social Security Benefits

Under IRC Section 86, the modified income used for Social Security taxation also includes tax-exempt interest. If that modified income plus half your Social Security benefits exceeds $25,000 (single) or $32,000 (joint), up to 50% of benefits become taxable. Above $34,000 (single) or $44,000 (joint), up to 85% of benefits can be taxed.¹⁰ Those thresholds have never been adjusted for inflation, so they catch more people every year. An investor collecting $40,000 in muni interest can pay zero federal tax on that interest while triggering thousands of dollars in tax on Social Security benefits.

Exceptions That Limit or Remove the Exemption

Private Activity Bonds and the AMT

A private activity bond is issued by a government entity but finances a project that primarily benefits a private business. IRC Section 141 classifies a bond this way when more than 10% of proceeds are used for private business purposes and more than 10% of debt service is secured by or derived from private business payments.¹¹ Airport terminals leased to airlines, industrial parks with private tenants, and stadiums operated by professional teams are typical examples.

These bonds lose the exemption entirely unless they fit one of seven “qualified bond” categories, which include exempt facility bonds, qualified mortgage bonds, qualified small issue bonds, qualified student loan bonds, and qualified 501(c)(3) bonds, among others.¹¹ Qualified bonds keep the interest exemption, but the interest is a tax preference item for the Alternative Minimum Tax.¹²

The AMT is a parallel calculation that adds preference items back into income and applies its own exemption and rates. For 2026, the AMT exemption is $90,100 (single) and $140,200 (joint), with phase-outs starting at $500,000 and $1,000,000.¹³ Investors with significant private activity bond holdings and income approaching those levels should check whether the AMT creates additional liability.

Arbitrage Bonds

Section 103 also denies the exemption to arbitrage bonds. Under IRC Section 148, a bond is an arbitrage bond if the issuer takes the borrowed proceeds and invests them in securities yielding materially more than the bond’s own rate. The rule prevents governments from borrowing cheaply and pocketing the spread. Issuers who earn excess investment income on bond proceeds must rebate the profits to the U.S. Treasury; failing to do so causes the bonds to lose the exemption entirely.¹⁴ You don’t control this as an investor, but an issuer’s violation can retroactively make bonds in your portfolio taxable, so if you’re buying individual munis, review the offering documents and any bond counsel opinion on arbitrage compliance.

Call Risk and the Income Stream

Many munis include call provisions that let the issuer repay the bonds early, usually when rates drop. If your bond is called, you get your principal back, sometimes with a small premium, but the stream of tax-exempt interest stops.¹⁵

The real cost is reinvestment. If rates have fallen far enough for the issuer to refinance, you’ll probably reinvest at a lower rate. A 5% bond called after five years might leave you reinvesting at 3.5%, losing $150 a year on every $10,000 of principal for what would have been the remaining term.¹⁵ Before buying a callable muni, look at yield-to-call rather than yield-to-maturity. If the bond trades at a premium and gets called early, the yield-to-call will be meaningfully lower than the headline.

Reporting on Your Return

Tax-exempt interest still has to be reported. On Form 1040 you enter the total on Line 2a.¹⁶ Your broker or paying agent sends a Form 1099-INT showing tax-exempt interest in Box 8. If you hold private activity bonds subject to AMT, that portion appears separately in Box 9.¹⁷ Tax-exempt OID is reported on Form 1099-OID in Box 11 rather than on the 1099-INT. If you hold muni bond funds, the fund reports exempt-interest dividends on Form 1099-DIV in Box 12, and that amount goes on Line 2a as well.

The reporting matters because the IRS uses the Line 2a figure to determine whether your Social Security benefits are taxable and whether you owe Medicare surcharges.¹⁶ Leaving the line blank because “it’s not taxable” is a common mistake that draws IRS notices.

1
Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds
2
Municipal Securities Rulemaking Board. Municipal Bond Basics
3
Office of the Law Revision Counsel. 48 USC 745 – Tax Exempt Bonds
4
Municipal Securities Rulemaking Board. What to Expect When Selling Municipal Bonds Before Maturity
5
Municipal Securities Rulemaking Board. Tax and Liquidity Considerations for Buying Discount Bonds
6
Internal Revenue Service. Guide to Original Issue Discount (OID) Instruments
7
Internal Revenue Service. Publication 550 – Investment Income and Expenses
8
Social Security Administration. Medicare Income-Related Monthly Adjustment Amount – Life-Changing Event
9
SSA – POMS. Modified Adjusted Gross Income (MAGI)
10
Office of the Law Revision Counsel. 26 USC 86 – Social Security and Tier 1 Railroad Retirement Benefits
11
Office of the Law Revision Counsel. 26 USC 141 – Private Activity Bond; Qualified Bond
12
Office of the Law Revision Counsel. 26 USC 57 – Items of Tax Preference
13
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
14
Office of the Law Revision Counsel. 26 USC 148 – Arbitrage
15
FINRA. Callable Bonds – Be Aware That Your Issuer May Come Calling
16
Internal Revenue Service. Instructions for Form 1040
17
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID