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For some investors, maximizing their investment income
is an important goal. One of the easiest ways to do this may be investing in municipal bonds, sometimes called "munis."
Because interest earned on munis is completely free of
federal income taxes, they are one of the most popular taxadvantaged
investments, especially for investors in high
tax brackets. Some munis also avoid state income taxes.
An investor can diversify across muni bonds by purchasing
a municipal bond mutual fund.
Look around when you drive down the freeway, and you'll see why munis exist. State and local governments issue these debt obligations to finance the building of such things as airports, bridges, highways, and hospitals. Today, investors hold over $2 trillion worth of muni bonds. Quick facts about municipal bond funds.
Things to consider
Is a municipal bond fund right for you?To determine whether a municipal bond is appropriate for you, you need to consider your tax bracket and the yield you would get after taxes. It's important to note that municipal bonds often have lower yields, however, because interest is tax-free, it may still be an attractive investment for your portfolio. Knowing how to calculate a tax-equivalent yield can help you decide.How to calculate your tax-equivalent yield.Would you benefit from investing in a municipal bond mutual fund? Always compare your tax-equivalent yield with the yield available on a taxable bond fund that has similar characteristics.When you compare the yield on a muni bond fund to the yield on a taxable bond fund, your tax bracket is the most important consideration. As a rule, munis become more attractive the higher your tax bracket is. For example, if you're in the 35% tax bracket earning a federal tax-free yield of 4%, you would have to yield 6.2% in an equivalent taxable bond fund to equal the 4% federal tax-free yield. By comparison, a person in the 10% tax bracket shows only a fractional difference on the same investment.
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