Municipal bond interest is generally tax-exempt at the federal level, and if the investor resides in the issuer's state, is also exempt from state taxes. Which statement best reflects this?

• A. It is tax-exempt federally, and may be state-exempt if residing in issuer's state
• B. It is taxable at the federal level
• C. It is always fully taxable in all states
• D. It is only tax-deductible

Answer: (A)

Municipal bond interest is designed to be tax-advantaged: you don’t pay federal income tax on it. In addition, many states extend that benefit to residents of the issuing state, making the interest exempt from state income tax for those individuals. So the statement that best captures this is that the interest is tax-exempt federally, and may be exempt from state taxes if you live in the issuer’s state. If you reside outside that state, you’d typically owe state tax on the interest to your own state, though rules can vary by state. Also, remember that this is about tax-exempt interest, not a deduction.