The Under 40 Financial Planning Guide: Invest in Tax-Free Municipal Bonds

Tax-free investments, such as municipal bonds or mutual funds that invest in municipal bonds, allow you to earn interest that is tax-free. Tax-free bonds usually pay less interest than comparable taxable corporate bonds. In order to compare them, you'll need to know the tax-free interest rate, the interest rate of a comparable taxable investment and your tax bracket. The formula is:

Taxable Interest - (1 - Your Tax Bracket) = After-Tax Interest

Use this formula to calculate the after-tax interest on a taxable bond. If the after-tax interest from the formula is less than the interest rate on the tax-free bond, you will want to invest in the tax-free bonds. Generally, if you are in the middle tax bracket or higher, tax-free bonds provide you with better after-tax earnings.

Keep in mind that bonds issued by your home state or city may also be free from state and local taxes. These may be referred to as Double Tax-free or Triple Tax-free. For certain larger states, such as California, New York, New Jersey and Florida, there are mutual funds that invest only in bonds which are free of federal and state taxes.