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Should You Invest in Municipal Bonds?

Answers to 9 common questions about tax-free bonds

5. What about the alternative minimum tax?

Income from certain municipal bonds may be subject to the alternative minimum tax, which limits what the federal government deems to be excessive deductions for certain taxpayers. Financial planners say retirees generally must be quite well off before the AMT affects them.

Social Security is also a potential tax issue if you’re collecting benefits. Muni interest is tax-exempt but still figures in the formula used to determine whether any of your benefits are taxable.

6. Are there any risks?

Municipal bonds fell in value about a year ago as analysts began predicting more defaults by issuers. Sluggish economic growth and reduced tax revenue had slammed spending by state and local governments. But defaults have actually decreased recently and history suggests that the chance of a default on high-grade munis is minimal.

7. So risk is no concern at all?

Not quite. There are still potential pitfalls.  As with all bonds, if inflation and interest rates go up, the purchasing power of interest income is likely to decline — as would bond prices. That could mean taking a loss if you need to sell your bonds before they mature.

8. So, what’s the case for buying munis now?

“Most municipalities have tightened their belts,” says Bill Walsh, president of Hennion & Walsh, a Parsippany, N.J., financial advising firm. “They have spent less money, provided fewer services and become fiscally responsible in recent years.” That means less chance of default.

And if tax rates rise as a result of a deficit reduction deal in Washington — as some analysts predict — munis with their protection from taxes will become more valuable.

9. What types of bonds should I focus on if I want to raise my potential returns and keep risk low?

The consensus is: Stick with high-quality bonds that may provide a bit less income but far greater security. “For a conservative investor who wants to buy munis and not worry about them, our advice is to own A-rated general-obligation and essential-service bonds,” says Patrick Early, chief municipal analyst at Wells Fargo Advisors. Essential service bonds are ones used to finance the most vital projects, such as power and sewage plants.

Also of interest: Check out our Investment Returns calculator. »

Conrad de Aenlle has written articles on finance and investment for more than 20 years.

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