FastFacts: Municipal Bonds

The basics: State and local governments and agencies issue municipal bonds. The interest munis pay is generally exempt from federal income taxes, and in many cases, from state and local taxes as well. However, any investment gains made from the sale of municipal bonds are taxable.

Because of their tax-exempt status, municipal bonds pay lower interest rates than taxable bonds. Whether you'll benefit from a municipal bond's tax advantage depends on your tax bracket. The key is to look at a muni’s taxable equivalent yield; that’s what you would have to earn in a taxable investment of similar quality for an equal return.

Since the interest paid on municipal bonds is generally tax free, munis are not appropriate investments for traditional IRAs and other tax-deferred retirement accounts. That's because money withdrawn from these accounts is considered taxable income, regardless of what it was invested in.

The risks: Like other types of bonds, municipal bonds are subject to interest-rate risk and credit risk. General obligation bonds, sold to finance roads, schools, and government buildings, typically have high safety ratings because they’re backed by the full faith, credit, and taxing power of the issuer. Revenue bonds, issued to raise money for specific projects, such as airports, toll roads, and toll bridges, are usually backed only by the funds raised by that particular project.

How to buy: Depending on how much you have to invest, you can buy municipal bonds individually, or through mutual funds. You can also buy munis through unit investment trusts, which are investment companies that invest in a fixed portfolio of securities.