Did you ever wonder why some investments are tax-exempt? Most people don’t wonder about this because tax-exempt bonds have been around for so long. But the distinction between taxable and tax-exempt investments goesback to a 1819 case where the Supreme Court ruled that the federal, state, and local governments do not have the power to tax each other. Thus,federal bonds are exempt from state and local taxes, and municipal bonds – those issued by states, cities, school districts, and other political subdivisions – are exempt from federal taxes. In addition, if you buy thebonds issued by the municipality in which you live, your investment is usually exempt from state and local tax, as well as federal tax.

Did you ever wonder why some municipal bonds are called general obligation bonds and others are called revenue bonds? The difference between the two generally depends on the project being financed. If a municipality is financinga project that will not produce revenue, it uses a general obligation bond backed by the full faith, credit, and taxing power of the municipality. If, onthe other hand, a municipality is financing a project such as a toll road or a convention center that can be expected to produce revenue, it will use a revenue bond – backed by the ability of the project to produce revenue.

Typically, the general obligation bond is considered a higher-quality investment.

Did you ever wonder why people would prefer a taxable investment over a tax-exempt investment? Generally, if both investments are paying the same rate of return and are of equal quality, you’re better off with the tax- exempt investment. But that’s rarely the case. Taxable investments usuallypay a higher rate of return, and you have to consider your particular tax bracket to determine which investment is better for you.

Here’s a simple, two-step formula to help you find your crossover point – the point where a taxable investment produces the same return after taxes as a tax-exempt return: (1) Subtract your marginal tax rate from 100 percent and (2) divide your tax-exempt rate by the resulting percentage.

The result is the yield you would have to secure from a fully taxable investment to equal your tax-exempt rate of return. For example, if you arein a 28 percent marginal federal tax bracket, your crossover point on a tax- exempt investment returning 6.5 percent is 9 percent. The calculation: 100percent – 28 percent = 72 percent; 6.5 percent or by 72 percent = 9percent. If the investment is free from state and/or local taxes as well,that tax rate should also be taken into account.

Did you ever wonder why those who invest in municipal bonds take different approaches? The approach an investor takes will probably depend on his or her investment needs or desires. For example, if you want to invest long-term, but you want to protect yourself against rising interest rates, you might use the so-called “ladder approach.” With $250,000 to invest, forinstance, you might stagger your bond purchases so that $25,000 of bonds mature each year. Then, as they mature, you can reinvest the proceeds foranother 10 years.

If, on the other hand, you want long-term growth with some liquidity, you might use the “barbell” approach. Again, assuming a $250,000 investment,you might put $175,000 in 10-year bonds for growth and the remaining $75,000 in one-year bonds for liquidity. Once more, your particular approachwill depend on your particular circumstances. Did you ever wonder which arethe best investments for you? Most likely, you have, especially if you adapt to changes in your life and as you plan for the future. You may want toconsider consulting a Financial Advisor to obtain more information on developing a long-term investment plan.

ALAN S. MOORE, who writes this column every Wednesday for L’Observateur, is a financial advisor of Legg Mason Wood Walker Inc., a diversified financialservices and securities brokerage firm that is a member of the New York Stock Exchange and SIPC.

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