Balance factors in municipal bond investments

Although each type of investment is unique unto itself, there is one thing that generally separates municipal bonds ("munis") from the rest of the pack: taxes. Specifically, munis have three distinct tax advantages over most other comparable investments. Furthermore, a new tax break in the economic stimulus act adds some icing on the cake.

The three main tax breaks for munis are as follows:

1. Muni interest is generally exempt from federal income tax. In other words, although a muni may yield a lower return than a comparable taxable investment, the actual return from the muni may be greater. Example: For an investor in the 28% tax bracket, a municipal bond with a yield of 6% is the equivalent of a taxable investment with a yield of 8.33%. Note: These figures are for hypothetical purposes only and are not indicative of any particular investment or yield.

2. Muni interest may also be exempt from state income tax. For instance, if an investor pays a combined (federal and state) 38% tax on his or her top dollars, a 6% muni issued by the investor's state is equivalent to a 9.68% return on a taxable investment.

3. Certain itemized deductions and personal exemption amounts are phased out for high-income taxpayers, depending on their AGI. However, tax-free interest does not count toward your AGI, so investing in munis can help you minimize or avoid the reduction.

On the downside, you should also consider other factors concerning municipal bonds, although one of these potential disadvantages has been eliminated this year.

*Alternative minimum tax: The interest earned on a certain class of municipal bonds--called "private activity" bonds--is exempt from regular income tax but is treated as a tax preference item for purposes of the alternative minimum tax (AMT). Such investments could effectively increase your overall tax liability. New tax break: The new stimulus law suspends this rule for 2009 and 2010. During these two years, investments in any type of municipal bond--including private activity bonds--are excluded from the AMT computation.

*Social Security benefits: Up to one-half of an individual's Social Security benefits is subject to tax if one-half of the benefits plus modified AGI (MAGI) exceeds certain thresholds. For this purpose, MAGI includes municipal bond income. In other words, an investment in municipal bonds can increase the tax on Social Security benefits.

*Call features: Most munis have call provisions that allow the issuer to redeem the bonds before maturity. The exact provisions can differ significantly between bonds, so carefully review these provisions before purchasing a bond.

*Redemptions: Consider the possibility that you may have to pay income tax on a municipal bond when you redeem it if you bought the bond at a discount from par value.

If you are interested in investing in munis, conduct a careful review of the authority issuing the bonds. Also, remember to keep your portfolio diversified to reduce the risks associated with any particular investment.