Municipal bonds

The higher your federal tax bracket, the more attractive municipal bonds, popularly known as munis, may be to you — even though they typically pay interest at a lower rate than similarly rated taxable bonds. And if you live in a high-tax state, these bonds may be even more appealing. That's because muni interest is exempt from federal income tax, and from state tax if you're a resident of the state where the bond was issued.

In most cases, you buy munis in $5,000 increments, though there may be exceptions if certain issuers want to make their offering available to a larger number of investors.

While all munis share their tax-exempt status, they're not all alike. Some pose more risk of default than others because the state and local governments that issue them aren't on firm financial ground. Some, called general obligation (GO) bonds, are backed by the full faith and credit of the issuer, which means residents' taxes pay the interest. In contrast, interest on revenue bonds is paid by the income generated by the particular project being financed. Generally speaking, revenue bonds are riskier than GOs.

		Municipal bonds

Par value		$5,000 and up

Terms		1 month to 40 years

Trading details		Through brokers

Risk		Variable

Interest		Federally tax-exempt, sometimes locally tax-exempt

Call provisions		Sometimes callable

Rated		Moody's, S&P, Fitch

Munis, while a smart choice for many investors, may not work as well for others. Experts advise against buying them for tax-deferred retirement accounts because all withdrawals from those accounts are taxed — even muni bond interest. And investors in the lower tax brackets may find they actually put more in their pockets with taxable bonds.

Alexandra Lebenthal, President and Chief
Executive Officer of
Alexandra &
James, Inc.

AMT bonds are clearly identified as subject to the alternative minimum tax, so if you have enough tax write-offs and preferential income to trigger a potential AMT liability, avoid them. But if you don't have AMT liability, AMT bonds may be windfalls. That's because to compensate for the potential tax liability they could trigger, they have to pay higher interest.

Compare the yield on a taxable bond with the yield on a tax-exempt municipal bond to find out how much you'd have to earn on a taxable bond to equal the yield on one that was tax-exempt.

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