Selecting a municipal bond ETF is different from selecting an individual municipal bond, and it is also different from selecting an equity ETF.
The Tax Treatment
The interest earned on most municipal bonds is exempt from federal income taxation. Most states and cities that levy income taxes exempt their own local bonds from taxation. Thus, a California resident who owns a municipal bond issued in California, or an ETF that invests only in California municipal bonds, would earn income that is exempt from both federal and state income taxes.
Keep in mind that it is only the income that is exempt—as with other investments, capital gains are taxed.
Because of the tax advantage of owning local bonds, in-state municipal bonds issued in higher-tax states often trade at a lower yield because prices are “bid up” by local investors wanting to hold local double-tax exempt bonds.
As a result, out-of-state investors may not find yields from the specialty-state ETFs to be as attractive as some other ETFs. In addition, in-state investors should always do the math to determine if they are really better off buying local, because in some cases, out-of-state yields can be sufficiently higher to justify buying an ETF that is holding out-of-state bonds and paying the local income taxes.
