What are tax-free investments?

State and local governments around the country issue a large quantity of debt securities to raise needed capital. The majority of these securities—often referred to as municipal bonds or simply "munis"—provide investors with interest that is exempt from federal income taxes. This income may also be exempt from state and local taxes for investors who reside in the issuing state or locality. A New York City bond, for example, would be triple-tax-free (i.e., exempt from federal, state, and local taxes) for an investor living in New York City. Because of this tax exemption, the terms "tax-free investments" and "municipal investments" are often used interchangeably.

What different types of municipal securities are available to investors?

General obligation bonds (GOs) and revenue bonds are two major classes of municipal securities differentiated by the source of funding for their interest payments. GOs are issued to finance various government operations and are backed by the issuer's power to raise taxes, if necessary, to make scheduled interest and principal payments. Revenue bonds, meanwhile, finance specific projects, such as transportation and utilities, and are backed by the revenue generated from the projects. Due to their potentially variable cash flows, revenue bonds are often considered riskier than GOs.

In addition, municipalities sometimes issue securities to help finance private development considered beneficial to local economies. The income from these "private activity" bonds is exempt from federal income tax but may be subject to the alternative minimum tax.

Municipal securities are issued for a wide variety of purposes and, as such, have varying maturities and yields. Many munis are short-term notes issued in anticipation of pending tax receipts or other revenues. These money market securities generally offer low yields due to their short maturities. Major projects, on the other hand, tend to be funded by longer-term bonds offering higher yields. In either case, coupon payments may be fixed or tied to a floating interest rate that resets periodically.

What factors should investors consider when choosing between taxable and tax-exempt securities?

Due to the potential tax advantage, investors typically accept lower yields from munis than they would from similar taxable securities. Because of this yield differential, one's tax status plays a major factor in the attractiveness of tax-free investments. While municipal securities could benefit investors in any tax bracket, they tend to appeal the most to those who are in the highest tax brackets or live in high-tax jurisdictions.

A simple way to gauge whether investing in a given municipal security would be more attractive than investing in a comparable taxable security is to calculate its equivalent taxable yield. This can be done in three steps:

(1)   Find the current yield of the tax-free investment you are considering (e.g., 5%).
(2)   Subtract your federal tax bracket, expressed as a decimal, from 1.0
(e.g., 1.0 – 0.25 = 0.75).
(3)   Divide the tax-free yield in step 1 by the number obtained in step 2
(e.g., 5% ÷ 0.75 = 6.67%).*

In this example, an investor in the 25% tax bracket would need a taxable security yielding at least 6.67% to receive the same amount of income, after the deduction of federal taxes, as a tax-exempt security yielding 5%. If no such taxable security is available, the tax-free security would be the better option. Of course, investors should make sure to compare securities with similar risk attributes such as credit quality and time to maturity.

In addition, the decision to invest in tax-free securities should be made in the larger context of maintaining a diversified portfolio of stocks and bonds that is in line with your risk tolerance, time horizon, and investment objectives. Also bear in mind that tax-free securities typically are not appropriate for inclusion in tax-deferred accounts such as IRAs.

Are there risks associated with municipal securities?

Like other types of fixed income securities, munis are subject to interest rate and credit risk. Interest rate risk is the potential for price fluctuations due to changes in interest rates—as interest rates rise, bond prices fall (and vice versa). In general, the longer a bond's maturity, the more sensitive its price will be to interest rate movements.

Credit risk is the possibility that the security issuer will not be able to make scheduled interest or principal payments. Although municipal bond defaults historically have been rare events, a weak local economy and reduced tax revenues could present serious challenges for a state or local government's finances. To gauge credit risk, the major credit rating agencies grade municipal bonds' credit qualities in a similar manner to corporate bonds. A downgrade to a bond's credit rating could result in a lower bond price and a higher yield to compensate for the additional risk.

Other municipal market risks include liquidity risk—or the ability to easily sell a security, if needed, at a desired price—and uncertainty about future tax laws. In addition, some income may be subject to the federal alternative minimum tax.

How can investors gain exposure to tax-free investments in their portfolios?

You can purchase municipal bonds through a broker or bond dealer. Another option is to invest in a mutual fund focused on municipal securities. Many large fund companies offer tax-free bond and money funds for investors nationwide as well as funds targeted to residents of certain states. Funds may also focus on specific credit-quality or maturity segments of the municipal  market.

What are the benefits of tax-free mutual funds?

A major benefit of mutual funds is diversification. When buying individual bonds, it may be difficult to develop a portfolio that has a sufficiently diverse range of holdings to reduce the impact of losses on individual securities. Tax-free mutual funds—even those investing in a single state—often hold dozens of different issuers and types of securities. Of course, diversification cannot assure a profit or protect against loss in a declining market.

Mutual funds also have professional managers and municipal analysts who perform the essential credit research and security selection processes that would be time-consuming and impractical for most individuals to do on their own. Funds also provide liquidity by allowing investors to easily sell all or a portion of their shares at the day's closing market price, often without the transaction costs associated with individual bonds. Finally, many fund companies offer conveniences such as automatic dividend reinvestment and checkwriting on eligible accounts/funds.

Are there drawbacks to tax-free mutual funds?

A downside to municipal funds is that they do not have fixed coupons or maturity dates like individual bonds. Thus, there is less certainty about future income. With an individual bond, an investor knows—barring a default or the early retirement of a bond with a call option—the timing and amount of cash flows.

Another downside to municipal funds is the possibility of taxable capital gain distributions. Although investors in individual bonds may be subject to capital gains taxes if they sell municipal securities above their purchase price, they have greater control over the distribution decision.

Investors should also carefully compare a mutual fund's annual expense ratio, which is expressed as a percentage of fund assets, with the costs and fees they would incur from purchasing individual muni bonds.

Who should consider tax-free investments?

Investors often overlook municipal securities when building a portfolio. Due to the potential for lower investment taxes and regular income, investors in every tax bracket should consider whether munis are a good fit for the fixed income portion of their portfolios. This is especially true when there are expectations for tax rates to rise.

*A more precise approach is to also consider state and local taxes that are deductible at the federal level. To do this, subtract your combined state and local tax rate, expressed as a decimal, from 1.0, and then multiply the result by the number obtained in step 2. Finally, divide the tax-free yield in step 1 by the product of the two numbers.