Municipal bonds are debt instruments used to raise money to build schools, highways, hospitals, sewer systems and other public projects. When you purchase a municipal bond, you are lending money to a state or local government to finance these public projects. The state or local government promises to pay you a specified amount of interest (usually paid semiannually) and return the principal they borrowed to you on a specific maturity date. Most municipal bonds offer income that is exempt from federal, state and city taxes if applicable, provided you reside in the state or city that is issuing the municipal bonds.
Not all municipal bonds offer income exempt from both federal and state taxes. There is an entirely separate market of municipal issues that are taxable at the federal level, but still offer a state, and often local, tax exemption on interest paid to residents.
