Question: I don't think you've ever written about municipal bonds. Who are they best for? Are they better than corporate bonds, which I own?

Nick Ackerman

Answer:

Dear Nick, Good question. There's so much to be discussed when it comes to municipals, that we'll run a two-part series on the topic. So, I thank you for asking about them.

Corporates vs. Municipals

Both bonds have a place in most portfolios. Here are the details.

Corporate and municipals both pay a set rate of interest twice a year for the life of the bonds and, if you hold them until maturity, you'll get back the full face value -- $1,000 per bond.

And, as you probably know since you own them, corporate bonds almost always pay a higher interest rate than municipals.

Tax Advantages of Municipals

Municipals, on the other hand, which are issued by cities, counties, states and other public agencies -- such as school districts, sewer and water districts and airport, bridge and tunnel authorities -- to finance various projects, come with definite tax advantages. To offset their lower yields, their interest is exempt from federal income tax and, in many cases, from state and local taxes for residents of the area where issued.

For example, if you live in New York City and purchase a bond issued by a city agency, you will not be required to pay federal, state or local income tax on the interest earned.

Caution: Just to complicate matters, some munis are actually taxed. Bonds issued to finance private business activities such as sports stadiums and parking facilities are often exempt from state and local taxes but are subject to federal income tax. So you want to check the details before purchasing.

These taxable municipals or private activity bonds as they're called, generally have higher yields than fully tax-exempt municipals.

$Tip: Munis issued by the U.S. Territories -- Puerto Rico, Guam and the Virgin Islands -- are tax exempt in all 50 states.

A Helpful Formula

A-rated (or insured) municipals are essentially a good choice for anyone in the higher tax brackets. And you don't have to be a millionaire to benefit from their tax-exempt status. On the other hand, they make sense only if the interest earned is more than the after-tax yield of a taxable investment.

For most people, that means being in the 28% tax bracket or higher. (Tax brackets are adjusted for inflation each year.)

To determine whether to buy a municipal bond or not, use this formula:

1. Subtract your tax bracket from the number 1. For example:

1 - .28 (28% tax bracket) = .72

2.Then divide the tax-free yield the bond is paying by .72 to find the taxable equivalent: 6% divided by .72 = 8.33%

3. The result, in this case, 8.33% is the yield you need on a taxable investment to match the tax-free yield of 6%.

Let's look at another example. If you're in the 31% bracket, a muni yielding 5.5% is equivalent to a taxable bond yielding almost 8%.

1 - .31 = .69

5.5% divided by .69 = 7.9%

Keep in mind that there is no point in putting a tax-free municipal in your IRA or other tax-advantaged account.

This formula should help you determine if municipals have a place in your portfolio. If so you can purchase them from Freedom Investments.

Stay tuned... next week we'll discuss the different types of municipals and how to determine their safety level.