States, cities, municipalities, and county governments can all issue municipal bonds, or munis, to raise money. They use the proceeds to improve roads, refurbish schools, or even build sports complexes. The bonds are usually rated by a major rating agency, such as Standard & Poor's or Moody's, based on the quality of the issuer.
Why do tax-sensitive investors like munis? Unlike income from bonds issued by corporations or the federal government, income generated by municipal bonds is exempt from federal, and sometimes state, income taxes.
To choose between a taxable and a municipal-bond investment, you need to know your tax bracket. A muni bond may seem to yield a lot less than a taxable bond, but it could be a different matter after you take your tax rate into account.
Say you're an investor in a higher tax bracket who's choosing between a corporate-bond fund yielding 7% or a muni-bond fund yielding 6%. The corporate-bond fund may seem like the better deal, because its yield is higher. After taxes, though, the muni fund could actually be the higher-yielding investment.
To learn more about choosing muni funds, see Funds 309: Choosing a Municipal-Bond Fund.
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