TAX EXEMPTION

Most municipal bonds are free of federal income taxes on interest distributions. Also, most are free of state and local taxes in the state in which they are issued. These features make them hugely popular among small investors. However, capital gains are not exempt from taxes. Municipals sold at discount are, because their earnings are considered interest and not capital gains.

The Tax Reform Act of 1986 created classes of bonds that are subject to federal income tax. Still, most investors and issuers use the term "municipal bond" to refer to the tax-free variety. Tax-free bonds are those that benefit the public. Taxable bonds are used in the private sector.

You can use a figure called the taxable equivalent yield to calculate how much you would need to earn on a taxable bond to equal what you are earning on a municipal bond. Taxable equivalent yield is calculated with the following formula:

Here is how it works. Imagine you pay federal taxes at 28 percent. Now suppose that you are considering buying a municipal bond that earns 6 percent interest. To calculate how much you would need to earn on a taxable bond to equal your 6 percent, enter the numbers:

You would have to earn 8.33 percent on a taxable bond to equal your 6 percent municipal bond. Many investors use taxable equivalent yields to help them choose which bonds to buy.

Now let's review what we have learned.