A conservative alternative to stocks

Mention tax-free municipals to some investors and you'll be greeted with a big yawn. "Munis," as they are called, are widely regarded as too conservative for aggressive investors looking for big capital gains. Others think of tax-free munis as beneficial only to wealthy investors in the top tax brackets. These days, both of those notions are wrong.

Contrary to popular opinion, you don't have to be in a top tax bracket to benefit from the tax advantages of municipal bonds, especially if you live in one of the states with high tax rates such as California, Connecticut, New York, Massachusetts and Pennsylvania. The interest on most munis is exempt from federal income tax and, usually, local and state taxes as well. That makes them a potentially good deal for a wide variety of investors

Of course, the higher your tax bracket, the more beneficial this favorable tax treatment becomes. However, even for middle-class investors in the 25 percent tax bracket, munis offer a competitive return coupled with far less volatility than equities.

Bond basics

As a rule, bonds, including munis, will rise in price as stocks fall, and vice versa.

Thus, when stocks take a plunge, bond prices often rise to cushion the shock. Municipals are essentially the equivalent of Treasury bonds, only on a local instead of a national basis. Regardless of your present tax bracket, munis can help to strengthen your financial position.

Keep in mind, however, that tax considerations are one of their major advantages. That is why it isn't practical to include munis in any tax-exempt retirement account such as a 401(k) or an IRA. However, if you're building a retirement nest egg in a taxable portfolio, munis can make a lot of sense.

Conversely, if you're saving for a child's college education, a municipal bond portfolio makes it possible for that money to grow without incurring a tax obligation.

It's important to understand that the yields on tax-exempt munis will usually be lower than on taxable corporate bonds. So, you should invest in tax-exempt securities only if your particular circumstances will allow you to save more in taxes than the additional amount you would earn from taxable investments.

Much as with stocks, building a solid portfolio of individually selected municipal bonds could prove to be a tough challenge for the typical small investor. That's why mutual funds make as much sense for bond investments as for stock investments. Almost every major mutual fund family offers a wide range of bond funds limited to individual states and a fixed range of maturities.

Finding the right fund

As with their equity counterparts, there are hundreds of different muni funds.

One way to find the right fund is to log on to http://www.morningstar.com/. Look for the funds that charge the lowest management fees and for funds that invest solely in munis from your own state, thus giving them tax-free status for both federal and state.

In addition to their ease of diversification, bond funds have the advantage of liquidity. Some individual municipals are thinly traded, so an investor who decides to sell before the bond's maturity could end up taking a loss. That's why, if you insist on buying individual municipals, you should plan to hold them until maturity.