Under present federal income tax law, the interest income you receive from investing in municipal bonds is free from federal income taxes.* Inmost states, interest income received from securities issued by governmental units within the state is also exempt from state and local taxes. In addition, interest income from securities issued by U.S. territories and possessions is exempt from federal, state and local income taxes in all 50 states.

One of the best ways to appreciate the tax-exempt advantage of a municipal security is to compare it to a similar taxable investment. Forexample, assume you are in the 36 percent federal tax bracket, file a joint return, and you and your spouse report $160,000 in taxable income.

Now assume you have $30,000 to invest and you are considering two investment alternatives: a tax-exempt municipal bond yielding 6 percent, and a taxable corporate bond yielding 8 percent. Which investment willprove most advantageous? If you invested your money in the municipal bond, you’d earn $1,800 in interest (a 6.0 percent yield) and pay no federal income taxes. The taxablebond investment, however, would provide you only $1,536 in income after federal income taxes have been deducted (a 5.1 percent yield). The municipal bond would provide the higher yield after taxes are taken into account. The tax-exempt security may be an even better investment ifyou accounted for state and local income taxes when calculating returns on a taxable bond investment.

*If you are subject to the federal alternative minimum tax (AMT), you must include interest income from certain private activity municipal securities issued after August 7, 1986 in calculating the tax.

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