Should You Buy Municipal Bonds?

"Munis" are debt obligations issued by a state or local municipal government or agency, often to support a specific public works project. With tax-free munis, you pay no federal taxes on the interest and no state or local taxes if the bond was issued in the state where you reside.

It doesn't make sense to invest in munis if you're in the 15% tax bracket. Single or joint filers in a higher tax bracket, however, should seriously consider buying them.

Dolan Smart Money Move: Should you buy munis instead of taxable bonds? Your decision should be determined by the effective yield of the tax-free bond you're considering.

The yield on municipal bonds is usually less than the yield you would get from taxable bonds of the same maturities. However, because you don't pay tax on municipal bond income, your actual "net" yield could be higher than the taxable yield you receive from corresponding corporate bonds, depending on your tax bracket.

To calculate your taxable equivalent yield, divide the tax-exempt yield by 1, MINUS your tax bracket. For instance, if you want to buy a municipal bond yielding 4.5%, and you're in the 36% tax bracket, your effective yield would be 5.47%.

Here's the math: 4.5 / (1 - 0.36), or 4.5 / 0.64 = 5.47%. So you would get the same amount of money in your pocket from both a high-quality municipal bond that is yielding 4.5% and a corporate bond that is yielding 5.47%.

As with all taxable versus tax-free decisions, we recommend that you check the taxable equivalent yield before you make your final decision. If munis do make good sense for you, invest in the highest-rated municipal bonds you can find, hold until maturity - and enjoy the tax-free income!

If you're looking for more information on munis, we recommend two excellent sites: www.bondsonline.com and www.investinginbonds.com.

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