People who fall within a high federal tax bracket should consider investing in municipal bonds. Municipal bonds are not only attractive in their liquidity and safety, but the most significant benefit is tax savings.

Since the enactment of the Federal Income Tax Amendment in 1913, the Internal Revenue Code has provided a specific exemption for municipal bonds. Municipal bonds are free from Federal, State and City income taxes for local residents.

By investing in municipal bonds, your interest payments will be free from federal taxes, and, if the municipality that issues the bond is located in your state, your interest payments also may be exempt from state and local taxes.

Because there is no tax on municipal bonds interest income, the interests paid on municipal bonds are generally lower than other types of bonds. This makes municipal bonds a great avenue for government agencies to fund projects at favorable rates instead of borrowing from financial institutions which have high loan interest rates.

The tax advantage of municipal bonds may be so great that you would have to earn a considerably higher interest rate on a taxable bond (such as a corporate bond) just to get the same after-tax return.

For example, suppose your tax bracket is 33 percent, you would have to find a taxable bond paying 7.46 percent to achieve the same after-tax return as what you would get from a municipal bond yielding 5 percent.

For another example, if you are in the 28 % tax bracket and make 7% on a taxable bond, you will keep 5.05% after taxes. That will be a better investment than any tax-free bond that returns less than 5.04%.

For yet another example, suppose your tax bracket is 25%, your state income tax rate is 5 % and you buy a state tax-free municipal bond that pays 4.5% interest. You would have to earn 6.32%, or higher, on a taxable bond of similar maturity and investment to match the 4.5% yield of your municipal bond. This 6.32% figure is the municipal bond's 'taxable equivalent yield.'' And your municipal bond would provide you with an even greater taxable equivalent yield if you were in a higher tax bracket.

So you must first determine whether your tax savings are significant enough to make up for the lower yield of municipal bonds before investing in one.

The yields on municipal bonds are therefore often articulated in terms of the taxable interest rate that would be required to provide the same after-tax interest rate. The formula for determining the equivalent taxable interest rate for municipal bonds is the following:

Taxable Equivalent Yield = IR / (1 - TR)

• IR = Tax-free Interest Rate of the municipal bond
• TR = Investor's Tax Rate

For example, say you have a marginal tax rate of 25%, and you are considering a tax-free municipal bond that pays 5%. Here is the calculation of the municipal bond's after-tax interest rate:

Taxable Equivalent Yield = 0.05 / (1 - 0.25)
= 0.067

To be more favorable than the calculated municipal bond, a taxable bond would have to offer you a yield higher than 6.67%.

Building a portfolio with a variety of short-term, intermediate-term and long-term municipal bonds (known as a bond 'ladder'') can help you in all types of interest-rate environments. When market rates are down, you'll have your long-term bonds locking in higher yields. But when market rates are up, you'll have the proceeds of your short-term bonds available to reinvest.

As with most bond funds, a municipal-bond fund's value rises and falls depending on interest-rate changes. To determine a fund's interest-rate risk, check its duration. A long duration usually means greater potential for short-term gains and losses. The intermediate-term municipal bonds with durations between 4.5 and 7 years have returned about 90% as much as long-term offerings, but with only about 70% of their volatility over the past 5 years.

High-quality municipal bonds also provide a range of interest rates at various maturities, to help you plan for short-term or long-term income needs. Depending on which bonds you choose, you can plan for income now and in the future as municipal bonds are issued with various maturities ranging from 1 to 30 years. Insured bonds earn AAA ratings (the highest) and are highly sensitive to interest-rate movements, but generally yield less than lower-quality bonds.

The quality of a municipal bond issuer is usually rated by major rating agencies such as Standard & Poor's and Moody's. Municipal bonds typically have very low default rates. According to the Bond Market Association, less than 1% of municipal bonds issued since 1940 have gone into either technical or actual default.

However, past performance does not guarantee future results. Municipal bonds are also usually issued with a credit enhancement, such as bond insurance, which helps provide a stronger assurance of timely payments.

Please note that yields and market values will fluctuate if the bonds are sold before maturity. Bonds are subject to market risk and, if sold prior to maturity, may be worth more or less than their original cost. Investors should keep in mind that as interest rates rise, existing bond prices of already outstanding fixed income securities tend to fall. Long-term bonds are generally more exposed to interest rate risk than short-term bonds.

Research on these areas before investing in a municipal bond:

• First, get to know your State's tax rate. Some municipal bonds invest all over the country, while others focus on a single state. National municipal bonds offer geographical diversification while single state municipal bonds provide residents with income that's exempt from both federal and state taxes. (National municipal bonds only give you the federal tax break.) Choose a single state fund if you live in a high-tax state. Otherwise, go national for the diversification benefits.
• Second, seek low costs. Costs are important factors for any investment. In any given year, the difference between the highest-returning and lowest-returning municipal bonds can be just a few percentage points. A small cost advantage therefore goes a long way. Invest in a municipal bond with an expense ratio of less than 1%.
• Finally, avoid Alternative Minimum Tax (AMT), if possible. You can still owe taxes on the income of municipal bonds if you're exposed to the AMT. Bonds subjected to the AMT tend to yield more than non-AMT bonds. If you're concerned about the AMT, choose a municipal bond that avoids AMT.