Strategy: Include municipal bonds in your portfolio. Previously, most munis provided tax-free income, but certain types of bonds, known as “private activity” bonds, could trigger alternative minimum tax (AMT) complications. The new law temporarily eliminates the AMT problem.

What’s more, municipal bonds have been more lucrative lately, with yields flirting with the 6% mark earlier this year. At one point, the yields for 10-year munis exceeded those for comparable Treasury securities.

Want to hear more? For starters, investing in municipal bonds can be a triple tax winner: 

1. Muni interest generally is exempt from federal income tax. Therefore, even if a muni’s yield is lower than a comparable taxable investment, the actual return may be greater. Example: If you’re in the 28% tax bracket, a municipal bond with a yield of 6% is equivalent to a taxable investment with a yield of 8.33%.

2. Muni interest on in-state bonds is exempt from state income tax. For instance, if you pay a combined top 38% tax rate (federal and state), a 6% muni issued by the state where you reside is equivalent to a 9.68% yield on a taxable bond.

3. Muni interest doesn’t increase your adjusted gross income (AGI). Personal exemptions and certain itemized deductions phase out when your AGI reaches annual thresholds. But tax-free muni interest doesn’t count toward your AGI. So investing in munis can minimize or avoid the reductions.

However, there are several potential tax pitfalls to watch out for with muni investments. One of the main concerns: The interest from most private activity bonds (i.e., bonds used to finance nongovernmental functions) is a tax preference item for AMT purposes. This may effectively force you to pay the AMT or increase an existing AMT liability.

Under the new law, interest from all private activity bonds issued in either 2009 or 2010 is exempt from the AMT calculation. (Previously, a 2008 law exempted certain housing bonds.) Also, tax-exempt interest on private activity bonds issued during this two-year span to refund private activity bonds issued between 2004 and 2008 won’t be treated as tax preference items.

Bottom line: You can invest in all newly issued munis right now without fear of AMT repercussions.

The new law also enhances existing bond programs and creates several new types of munis for investors to consider. This includes:

• A new category of tax credit bonds issued in 2009 and 2010 for investment in economic recovery zones
• Extending the scope of industrial development bonds for manufacturing issued by state and local authorities
• A new category of tax credit bonds issued by state and local authorities to finance qualified school construction
• Authorization for Native American tribes to issue tax-exempt economic development bonds
• Increased limits on Qualified Academy Zone bonds through 2010
• Modifications in the rules for bonds used to finance high-speed intercity rail facilities.

Tip: As income tax hikes loom on the horizon, there’s added incentive to invest in munis.

What’s the tax exemption worth?

The chart below shows taxable yields equivalent to tax-free muni yields for investors in the four highest federal income tax brackets.

Federal tax rate	3.5% muni yield	4% muni yield	4.5% muni yield	5% muni yield	5.5% muni yield	6% muni yield
25%	4.67%	5.33%	6.00%	6.67%	7.33%	8.00%
28%	4.86%	5.56%	6.25%	6.94%	7.64%	8.33%
33%	5.22%	5.97%	6.72%	7.46%	8.21%	8.96%
35%	5.38%	6.15%	6.92%	7.69%	8.46%	9.23%