How to Earn Interest Tax-free on Spare Cash (Municipal Bonds)

If you have extra cash sitting in a savings account, municipal bonds could be a better option. These bonds are issued by state and local governments. In many cases, the interest they pay is exempt from federal taxes. Some may also be free from state or local taxes, depending on where you live.

That means you could earn more from your spare cash without adding to your tax bill.

In this article, we’ll cover what municipal bonds are, how the tax benefits work, and simple ways to invest. If you’re looking for a low-risk way to put your cash to work, this guide can help you decide if municipal bonds are a good fit.

📌 Also Read: How Much Is the Standard Tax Deduction in 2024-2025?

What Are Municipal Bonds?

Municipal bonds — often called “munis”— are loans you make to state or local governments. When you buy one, you’re lending money to help fund public projects like roads, schools, or water systems.

Who issues them:

In return, the issuer pays you interest and eventually returns your original investment (the principal), when the bond matures.

How Interest Is Paid

Municipal bonds typically pay interest in one of two ways:

✅ Periodic “coupon” payments: Most bonds pay semi-annual interest directly to investors.

✅ Original Issue Discount (OID): Some bonds are sold at a discount and accrue interest over time.

📝 Note: If you earn tax-exempt interest, it’s usually reported on Form 1099-INT, box 8. You may still need to include this on your federal tax return, even if it’s not taxable.

Tax Advantages of Municipal Bonds

Municipal bonds are popular among investors who want to earn interest without adding to their tax bill. While not all muni bonds are treated the same, many offer tax benefits at the federal, state, or even local level. 

Here’s how the tax advantages generally work:

Federal Income Tax Exemption

Most municipal bonds pay interest that’s exempt from federal income tax. That means the earnings you receive typically won’t count toward your federal ordinary income. For those in higher tax brackets, this could make municipal bonds a more efficient way to earn interest.

State & Local Tax Exemption

If you buy municipal bonds issued in your home state, the interest may also be exempt from state and local taxes. These rules vary depending on where you live, so it’s important to check your state’s tax treatment before you invest.

AMT Triggers & Tax-Equivalent Yield

Some types of municipal bonds — called private activity bonds — may be subject to the alternative minimum tax (AMT). This can reduce the expected tax benefit. To see how a tax-free bond compares with a taxable one, you can calculate its tax-equivalent yield using this formula:

Tax-Equivalent Yield = Tax-Free Yield ÷ (1 – your marginal tax rate)

📌 Also Read: Tax-Exempt Governmental Bonds | IRS

Types of Municipal Bonds and Credit Quality

Municipal bonds come in a few forms, and understanding their structure can help you weigh potential returns against risk. Below are three key factors to know before investing:

General Obligation vs. Revenue Bonds

The way a bond is backed makes a big difference in how secure it may be.

General obligation (GO) bonds are backed by the full faith and credit of a state or local government. That means the issuer uses its taxing power—usually property or sales taxes—to repay the bond. These are generally viewed as lower risk.

Revenue bonds work differently. They’re tied to a specific project, like a toll road, hospital, or utility. Payments to investors come from the income that project generates. If that revenue falls short, the bondholder takes on the risk.

Insured vs. Uninsured Bonds

Some municipal bonds include insurance coverage, while others don’t. This insurance acts as a guarantee and can affect how protected your money is. If the issuer can’t pay, the insurer steps in to cover the principal and interest.

✅ Insured bonds may give added peace of mind because they’re backed by the insurer’s financial resources.

❌ Uninsured bonds rely only on the issuer’s ability to repay. If something goes wrong, you take on the full risk.

Understanding Credit Ratings

Before investing, it helps to know how strong a bond issuer’s finances are. That’s where credit ratings come in.

Credit rating agencies like Moody’s, S&P, and Fitch evaluate how likely an issuer is to meet its debt payments. Their ratings range from AAA (the highest) to D (default). Higher-rated bonds usually mean lower risk and offer lower yields. Lower-rated bonds offer higher yields, but they come with a greater chance of default.

It’s a good idea to check a bond’s rating. That way, you can better match your risk comfort level with your income goals.

How to Invest: Funds, ETFs, Ladders & Direct Purchase

Investors have several methods to access municipal securities:

✅ Municipal Bond Funds & ETFs

Municipal Bond Funds and ETFs typically hold dozens of bonds, so you can start with modest amounts. They may offer diversified exposure and professional management. Defined-maturity ETFs allow you to target specific maturities as you would with a direct ladder .

✅ Direct Bonds via Broker

You may buy individual muni bonds through full-service or discount brokers. This approach lets you choose exact issuers and maturities. Tax-exempt interest is reported on Form 1099-INT, box 8 .

✅ Laddering Strategies for Spare Cash

A bond ladder staggers maturities at regular intervals, say one bond per year over five years, to manage interest-rate and reinvestment risk. When a rung matures, proceeds may be reinvested or used as needed .

Municipal Bonds Risks & Alternatives

Municipal bonds may appeal for their tax advantages, but they’re not risk-free. Before you invest, it’s helpful to review the main downsides and compare other cash vehicles that could suit your needs.

Here are some of the risks to keep in mind:

❌ Interest-Rate Risk
Bond prices typically fall when interest rates rise. If you sell before maturity, you could realize a loss, even though your interest payments remain the same.

❌ Credit Risk
Most munis carry high credit ratings, but an issuer under financial stress might miss a payment or face a downgrade, which can hurt market value.

❌ Call Risk
Some bonds are “callable,” so the issuer could redeem them early if rates drop. You’d get your principal back but likely reinvest at lower yields.

Municipal Bonds Alternatives

✅ High-Yield Savings Accounts

These accounts typically offer around 4.40 percent APY, though rates generally fluctuate and are subject to ordinary income tax.

✅ Certificates of Deposit (CDs)

One-year CDs can pay approximately 4.49 percent APY, and earnings are generally taxable.

✅ Treasury Bills (T-Bills)

Short-term T-bills often yield about 4.24 percent, backed by the U.S. government. Interest is exempt from most state and local taxes but still subject to federal tax.

📝 Disclaimer: All yield figures are approximate and subject to change. They’re shown for illustrative purposes and may vary based on market conditions.

Key Takeaways

If you’re looking for a way to earn more from your idle cash without taking on too much risk, municipal bonds may be worth exploring. They typically offer interest that’s exempt from federal taxes—and in some cases, state or local taxes too. Depending on your tax bracket, that could result in a higher after-tax yield than many savings products.

If you’re thinking about your next move:

✅ Start by checking whether your state exempts in-state bonds from income tax.

✅ Consider whether you prefer individual bonds or want the simplicity of a muni bond fund or ETF.

✅ Look at your current cash allocation and see if a laddered bond strategy fits.

✅ Talk to a qualified financial or tax professional if you’re unsure which option is best.

Remember, tax rules and investment returns can change. What works well for one person may not be ideal for another, so take the time to weigh your options carefully.

📌 Looking to explore more? Check out our other articles about investments:

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