Tax-free municipal bonds can help balance portfolio

Just as important, but perhaps less obvious, is responsibility number two: getting maximum personal benefit from the money you earn.

One of the most important ways to accomplish that goal is to diversify your investments in a way that will help pave the road to financial security for you and your family.

The choice of some investments is obvious. Most experts say that every investment portfolio should include a mix of stocks, bonds and cash equivalents such as CDs and money markets. Experience proves that carefully thought-out diversification of those three elements is one of the most important keys to investment success.

Of course, each of those three classifications of investments includes its own range of choices. For that portion dedicated to bonds, the most common choices are corporate and U.S. Treasury bonds. Often neglected by the typical investor is a third choice - tax-exempt municipal bonds. These are investment instruments issued by local municipalities, school districts, sewer, water and highway authorities and other municipal functions.

In some ways, tax-free municipal bonds are among the most misunderstood investments. Referred to derisively by some brokers as best suited for only the most conservative investors such as "widows and orphans," municipals deserve more attention from the average investor.

Contrary to popular opinion, you don't have to be in a high 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 municipals is exempt from federal income tax and, usually, local and state taxes as well. That means you don't have to be in one of the top tax brackets to enjoy the benefits of tax exemption.

Smooth ride

As a rule, bonds, including municipals, will rise in price as bonds fall, and vice-versa. Thus, when stocks take a plunge, bond prices often rise to cushion the shock. Further, a look at market returns over the past five years reveals that municipal bonds have been one of the best performing of all investments.

Municipals are essentially the equivalent of Treasury bonds, only on a local instead of a national basis. Regardless of your present tax bracket, municipals can help to strengthen your financial position. However, since tax considerations are one of their major advantages, it simply isn't practical to include municipals 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, municipals 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 municipals 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.

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.

Except for tax considerations, investments in taxable corporate bonds carry much the same advantages and risks as municipals.