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Now might be a good time to get into tax free municipal bonds.  But how do I invest?  What are municipal bonds and how do I know if they are right for me?  Read on.

I'm sitting on a lot of cash right now.  Most of it's either in savings accounts or certificates of deposit.  I want to put that money to better use.  I think some of the money from the savings accounts would do much better in a tax free municipal bond or rather a fund that invests in tax Free municipal bonds.

What are Tax Free Municipal Bonds?

State and local governments borrow money for various purposes like building roads, bridges, water treatment plants or schools.  So your city may want to build a new water facility.  Chances are they don't have the cash on hand to pay for it, but the city needs it now.  So the city issues bonds.  Bonds are simply a financial instrument that let's someone borrow money with a promise to pay it back later.

Governments and businesses issue bonds all the time.  The US federal government is constantly spending more money than it takes in via taxes.  So to make up the difference the government issues Treasury Bills and Bonds.

Large business also issue bonds.  Business use the money for everything from making payroll to building plants and expanding operations.

Generally bonds allow entities to raise more money then they could get from a bank.  Could you imagine a bank large enough to finance the federal debt?

For more information on Tax-Free Municipal Bonds see the surprisingly educational Investing in Tax-Free Municipal Bonds for Dummies.

How Do I Know if Tax-Free Municipal Bonds are for Me?

Good question.  It depends on several factors.  But generally it's pretty easy to figure out.

• Are you looking for a generally secure and less volatile investment than the stock market?
• Are you in a high(er) tax bracket?
• Do you want to avoid the dreaded Alternative Minimum Tax (AMT)?

My Situation

Here's my situation.  I'm sitting on a large amount of cash.  This cash is for medium to long (10 years) term goals.  CD rates are alright but not that spectacular.  Same with online savings account.  Plus once you deduct taxes and inflation, you're left with about the same amount as you had before.  Also this year I might be pushed into a higher tax bracket.

I've always been curious about tax-free muni's.  On principal alone I like to pay as little tax as possible.  After all that's what our country was founded on.

The Calculations

There are some easy calculation to figure out if tax-free muni's are right for you.  First you need some yields.  Yields are the return that the bonds will offer.  Because I like the idea of bond funds and because I'm already a Vanguard customer, I'm using Vanguard bond funds in my example.

Morningstar has a tax free bond calculator.  You'll need some information.  You'll want to find the yield of the tax free bonds or bond fund, the yeild of the equivalent treasury bonds and then you'll need your state and federal (marginal) tax rate.

I've used the current yield from the Vanguard Long Term Tax Free Fund, 4.65% and the Vanguard Long Term Treasury Fund, 3.96%.  You can see that in 28% tax bracket, I'm much better off to invest in the tax free bond.

In fact, whatever tax bracket you're in, you're better off to take the tax free municipal bond option.  This of course assumes that the municipal bond fund and the treasury bond fund have the same safety/risk, which they don't.

All things being equal, the US Federal government is assumed to be one of the safest credit risks on the planet.  Of course that could change with the current finacial crisis.  However, I can't see the future so I have to use the information I have available to me.

Municipal bonds are issued by entities that usually have taxing authority.  That means, unlike corporations, they can usually raise more money to cover their debts.  This isn't always true, but muni's are usually safer than corporate bonds.

Future Tax Rates

For the time being, it seems that tax rates will stay the same, but the new president has stated he wants to raise taxes.  Considering how much money the US government is spending to bail out the financial sector, it seams at some point taxes will have to go up.  So tax free muni's purchases now, at a relatively cheap price, might be a good investment for the future.

Am I Missing Anything?

I've not invested in municipal bonds up to this point.  I'm a tad nervous as it's a new asset class to me.  I'm trying to find any details I may be overlooking?  If you have anything to add leave a comment below.

Further Reading:

'Barack Attack': Muni bond demand rises on tax-hike fears (LA Times)

Steals in Tax-Free Bonds (Kiplinger)

Muni yields aren't puny (Market Watch)

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