When you purchase a municipal bond, you're loaning money to a municipality, city, village, county, or state. Typically, the municipality borrows money to pay for infrastructure projects such as building or repairing roads or a community center. The municipality generally pays back the bonds with money made from those projects - by paying off a bridge bond with money that is raised from bridge tolls, for instance.

Most municipal bonds are exempt from federal taxes on the interest they earn. Additionally, if the bond is issued in the state that you live in, you may owe no state taxes either. However, interest on some municipal bonds, often called private activity bonds, can still fall into alternative minimum tax guidelines and to state and local taxes. Also, buying and selling municipal bonds can be subject to capital gains taxes.

Nevertheless, tax-free investments can make your portfolio more tax efficient, especially if you fall into a high tax bracket and if the current tax policies are changing for the worse. Municipal bonds can help you diversify your fixed income positions as well. Additionally, municipal bonds are generally considered low-risk adding steady income to your portfolio, thereby can be very attractive to risk-averse investors.

Tax-free vs. taxable bonds

Municipal bonds, because they are generally more conservative and because the income is protected from federal income taxes typically pay lower interest rates than comparable taxable bonds. If you fall into a higher tax bracket, then tax-free investments become more valuable to you.

To decide whether a tax-free bond is better than a taxable bond, convert the tax free yield into its taxable equivalent yield. The formula to accomplish this is simply: Tax-equivalent yield = Tax-free yield / (1- your federal tax bracket).

For example, let's say you want to get into a tax-free bond that pays 2%, and you're in the 28% federal income tax bracket. Further, assume you live in the state that issues the loan so there aren't any state or local taxes that apply to the municipal bond. For someone in your situation, the tax-free bond's equivalent taxable yield is 2 / (1 - 0.28). Your bond's tax-equivalent yield is 2.78%. That's potentially a good purchase if comparable taxable bonds are paying 2.5% but the arrangement might not be as lucrative if comparable taxable bonds are yielding 2.8%.

Let's look at another example. Say you and your spouse file jointly and report a net taxable income of $245,000 which makes you fall in the 33% federal income tax bracket in 2010. Assume that state and local taxes don't apply. Below is a small table that shows tax-free bond yields and their taxable equivalents.

In this situation the investor may consider purchasing a tax-free bond yielding 2.5% or a comparable taxable bond yielding 4%. In this scenario it would be wiser to buy the taxable bond, because the taxable bond's yield is greater than the tax-free bond's tax-equivalent yield of 3.73%. The table below shows possible tax-free bond yields and their taxable equivalents.

Municipal bond mutual funds

Municipal bond mutual funds offer greater portfolio diversification for investors that are not looking to dabble in individual bond purchases or want to buy into multiple municipal bonds.

The formula is the same as it is for a single bond. Say a taxable bond fund offers a yield of 3% while a tax free fund offers 2.5%. An individual that falls into the 28% tax bracket would find, using the previous formula, that the tax-free bond's tax-equivalent yield of 3.47% is more than the taxable bond's yield, making it a better decision to buy into the tax-free fund.