Municipal bonds, which are issued by state and local municipalities, offer interest payments that are exempt from federal taxes and may also be exempt from state and local income taxes, depending on where you live. These bonds typically offer lower yields than Treasuries because of their tax benefits.
To help decide between a taxable bond fund and a tax-exempt bond fund, take the taxable fund's yield and multiply it by 1 minus your tax rate. This is the fund's tax-adjusted yield. For instance, if you are in the 25% tax bracket and you are comparing a taxable-bond fund paying 4% with a muni fund paying 3.5%, you'd multiply 4% by (1 - 0.25) and compare that with 3.5%. On an aftertax basis, the fund with the 4% yield would yield only 3%. So in this case, the muni fund offers a higher aftertax interest rate.
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