Municipal bonds, or “munis,” carry an important tax feature: the interest paid on these bonds are exempt from federal income tax, as well as state and local income tax in the state in which they are issued. This could mean significant savings in taxes that could otherwise be flowing to the government. Munis are especially attractive to investors whose tax brackets are quite high, therefore garnering them a greater after-tax return from tax-free interest than they would realize from taxable interest.

Let’s consider a hypothetical example of the Smiths. Currently, they are in the 35-percent tax bracket. They are considering investing $100,000, but are unsure of whether they would benefit from municipal bonds. The bonds they are thinking about pay an interest rate of 6 percent. They are also looking at a bank CD for this money, which pays 8.2 percent. Which investment could earn them a higher aftertax return? The Smiths would earn 6 percent after tax from their muni bond, but they would only earn 5.33 percent after tax from the bank CD. Therefore, the muni bond would earn a greater after tax return for the Smiths. (See Tables 7.2 and 7.3 for comparisons with the updated tax brackets.)

(1 –  tax bracket) - taxable yield  = tax-free yield
   (1 –  .35) - 8.2% = 5.33%

When considering the tax implications of purchasing municipal bonds versus other fixed-income investments, also determine whether you will be paying state and local taxes on the interest and capital gains. Usually, the muni bonds will be exempt from state and local taxation. These are sometimes referred to as “triple-tax-free municipal bonds” because of the income tax exemptions on the interest and sometimes on the capital gains.

For example, the Smiths have a state income tax rate of 4.4 percent, no local income tax rate, and they itemize their deductions. Their effective state rate is 4.4 x (1 - .35) = 2.86 percent. Their total tax rate is 37.86 percent. In this case, the municipal bond they are considering would be free from state income tax, as well as federal income tax.

However, the bank CD yield of 8.2 percent isn’t exempt from any taxes. Therefore, their after-tax rate on the muni bond remains 6 percent, whereas the after-tax rate of the bank CD is 5.095 percent.

(1 –  .3786) - 8.2% = 5.095%
   Amounts  are hypothetical.

However, if the Smiths don’t itemize, or if the deductions are mostly phased out on their federal income tax return, and the state income tax they pay isn’t deductible or mostly deductible, their combined effective income tax rate is 39.4 percent. Then the after-tax yield on the bank CD would be 4.97 percent. It’s important to remember that this analysis doesn’t apply to U.S. Treasury securities or other direct government obligations because they are already exempt from state and local income taxes.

(1 –  .394) - 8.2% = 4.97%
   Amounts  are hypothetical.

There are many kinds of municipal bonds, in terms of how the bonds are backed financially. They include general-obligation bonds, special tax bonds, revenue bonds, insured municipal bonds and more.

GENERAL-OBLIGATION BONDS. Municipal bonds are usually not secured by physical property; instead, they are debts payable from the state or local governments’ general tax revenues. G-O bonds are normally considered to be high-quality and highly secure investments, in line with the creditworthiness of the issuer.

HOUSING AUTHORITY BONDS. Housing authority bonds are issued to pay for low-rent housing projects and are backed by the promise of unconditional, annual contributions by the Housing Assistance Administration, a government agency. These bonds are considered among the highest in quality.

INDUSTRIAL DEVELOPMENT BONDS. These bonds are issued either by a municipality or a municipal authority to finance and promote areas like industrial parks. They are backed by the lease payments made by the industrial companies that use or fill the facilities that are paid for by the bond issue.

Municipal bonds are also rated, just like corporate bonds are. The quality ratings for munis are second only to U.S. government and government agency securities. Moody’s and Standard & Poor’s, again, are the companies that rate these bonds.

INSURED MUNICIPAL BONDS. Although state and local municipalities who issue bonds are generally thought to have good credit, and thus, have highly rated bond issues, many muni bonds carry insurance to protect the investors from the default risk. Any insurance carried on the bonds strengthens their credit rating, usually up to the highest level.

REVENUE BONDS. The principal and interest on revenue bonds is paid from the income received from specific projects or entities. Examples of revenue bonds are water, sewer, gas, and electrical facilities; bridges, turnpikes, tunnels and highways; and hospitals and power plants.

SPECIAL TAX BONDS. These bonds are usually backed and payable through a single tax, or series of special taxes. They may also be payable through another specific income source.

Municipal bonds can be prerefunded, and are also subject to high credit ratings. Prerefunding a bond issue means that the issuing municipality has purchased U.S. government securities that have the same maturity term as the municipal bond. These securities are then held in a special account, where they are the collateral for the muni bond, therefore reducing the risk of default.

Similar to corporate bonds, muni bonds also have an interest rate risk and call provisions. However, you must determine whether the tax-free interest outweighs the possibilities of having your bond redeemed prior to maturity or having the interest rate increase. Usually, though, investors in higher tax brackets enjoy having some municipal bonds in their portfolios to help increase their overall, after-tax return on their investments.