Most municipal bonds are free of federal income taxes on interest distributions. Also, most are free of state and local taxes in the state in which they are issued. These features make them hugely popular among small investors. However, capital gains are not exempt from taxes. Municipals sold at discount are, because their earnings are considered interest and not capital gains.

The Tax Reform Act of 1986 created classes of municipal bonds that are subject to federal income tax. Still, most investors and issuers use the term municipal bond to refer to the tax-free variety. Tax-free bonds are those that benefit the public. Taxable bonds are used in the private sector.

You can use a figure called the taxable equivalent yield to calculate how much you would need to earn on a taxable bond to equal what you are earning on a municipal bond.

If you plug different tax brackets into the formulas for taxable equivalent yield, you will see that the higher your tax bracket, the higher the taxable equivalent yields will be. Therefore, the higher your tax bracket, the more you will profit from municipal bonds. This is why these bonds are very popular among high-income investors.