Tax-free bonds that pay the highest interest are issued by governments with low credit ratings. Financial advisers suggest sticking to highly rated bonds unless you're ready to take risks. Some mutual funds, including some money market funds, invest only in tax-exempt bonds. That may be an alternative to buying individual bonds. But the interest is subject to federal income tax.
Treasury bills have terms of up to a year.
Treasury notes have terms from two to 10 years, and Treasury bonds have terms of more than 10 years. Interest on notes and bonds is taxed annually, but interest on bills is taxed at maturity, or, if you sell before maturity, when the bills are sold. You also have to take federal, state and local tax rates into account, especially in high-tax states such as California and New York. If you're receiving Social Security benefits, tax-exempt income is added back to your other income to determine whether your Social Security income is taxable. But the higher your marginal tax rate is, the more likely you are to receive a greater net yield on a tax-free investment than on one that's taxed.