Can I Invest in Municipal Bonds to Reduce My Tax Bill?

Municipal bond interest is exempt from federal income tax and often exempt from state tax in the issuing state — making them attractive for taxpayers in higher brackets. To decide if munis make sense, compare the tax-equivalent yield: divide the muni yield by (1 minus your marginal rate). A 3% muni yield equals a 5% taxable yield for someone in the 40% combined tax bracket. Most municipal bonds are also exempt from the Net Investment Income Tax. Some "private activity" municipal bonds are subject to the Alternative Minimum Tax (AMT). Munis are generally better suited for taxable accounts — in an IRA or 401(k), their tax advantage is wasted since all growth is already tax-deferred.