• Municipal bonds are issued by state or local governments to raise funds for projects and expenses. These bonds are favored by investors who fall within the high income tax bracket because many municipal bonds are tax-exempt at the local, state, or federal level. However, not all municipal bonds are tax-exempt.
  
  

Tax Benefit

• Investors normally use municipal bonds to generate fixed income without having to pay taxes. Gains derived from municipal bonds issued by the home state of a purchasing investor, or by municipalities located within the state, are generally exempt from state income tax. However, if the investor purchases municipal bonds through secondary markets and thereafter sells the bonds for profit, gains from the sale will be taxable at long-term or short-term capital gain rates.
  
  

Considerations

• Investors must consider tax-exempt municipal bonds only if they belong to the high tax bracket. Tax-exempt municipal bonds offer much lower yields compared to taxable municipal bonds. The lower yield may offset any potential tax benefits from the bond. Investors must therefore determine whether the tax savings are significant enough to compensate for the lower yield. Otherwise, it may be more lucrative to invest in high-yielding municipal bonds.
  
  

Risk Factors

• Interest rate risk is a factor to be considered before investing in municipal bonds. Once a municipal bond is purchased, the bond's interest rate is locked in. This prevents the investor from benefiting from future increases in interest rates. If an investor believes that his marginal income would drop and cause him to slide to a lower tax bracket, he would be better off investing in high-yielding taxable bonds.