Under present federal income tax law, the interest income you receive from investing in municipal bonds is free from federal income taxes. In most 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 comparable taxable investment. For example, assume you are in the 33% federal tax bracket, file a joint return, and you and your spouse claim $175,000 in taxable income. Now assume you have $30,000 to invest and you are considering two investment alternatives: a tax-exempt municipal bond yielding 5.0%, and a taxable corporate bond yielding 7.0%. Which investment will prove most advantageous?

If you invested your money in the municipal bond, you'd earn $1,500 in interest (a 5.0% yield) and pay no federal income taxes. The taxable bond investment, however, would provide you only $1,407 in income after federal income taxes had been deducted (a 4.7% yield).

As you can see, the municipal bond would provide the best yield after taxes are taken into account. The tax-exempt security would be an even better investment if you accounted for state and local income taxes when calculating returns on the taxable bond investment.