Dear Dr. Don,

How can I invest in municipal bonds? If I go through a financial planner, would I have to pay a fee as in buying an annuity? Also, when I take money from the municipal bonds, would I have to pay taxes on the interest earned?

— Alice Asks

Dear Alice,

With all the financial pressures placed on state and local government from the current economic conditions, you pick an interesting time to decide to start investing in municipal bonds. Maybe you had a particularly painful tax season and are seeking some relief.

Municipal bonds are debt obligations of state and local governments. Interest income from municipal bonds is free of federal income taxes. In many states, when a resident buys bonds from municipal issuers in that state, the interest income is exempt from state income taxes as well.

Local income taxes can also encourage residents to buy local municipal bonds. For example, a resident of New York City can buy New York City municipal debt and have a triple tax exemption on the interest income — federal, state and local.

Make sure you understand the risks involved in buying municipals before taking the plunge. Many factors at play in the current economic downturn could influence the return on your municipal bond investment.

Factors include falling real estate prices that put pressure on assessed values, declining sales tax collections in many states, the financial worries of bond insurance firms and bond rating agencies’ ability to properly assess credit risk being called into question.

You can buy municipal bonds from a stockbroker, or you can buy a mutual fund that invests in municipal bonds. An advantage of a mutual fund is the professional management of the investment portfolio and the ease of diversifying across many municipal issuers.

Many municipal bond funds are segmented by state, so you can buy a fund that invests in the municipal debt of the state you reside in. By doing so, you can capture the state tax exemption on the interest income.

If you’re buying a newly issued municipal security, the issue pays a sales concession to the brokerage firm offering you the bonds, so you shouldn’t have to pay a sales commission. For a seasoned issue, the commission is usually built into the price you pay for the security, so there isn’t a separate fee.

How you pay your financial planner depends on the compensation model you’ve arranged with that planner. Such models include assets under management, some other type of fee-based model or a commission-driven approach. One way or another, you’re compensating your planner for the advice he or she provides. If you’re unsure how your planner is getting paid, you definitely need to have that conversation.

Municipal bonds are best held in taxable accounts rather than in tax-advantaged retirement accounts. Gains or losses on the sale of municipal bonds, other than those relating to the original interest discount, will have a tax impact. It’s only the interest income that is exempt.

If you are unsure of your tax situation, talk to a tax professional before investing in municipal bonds. For example, if you invest in “private activity bonds” — a special category of municipal bonds — the interest income could be taxable at the federal level if you are subject to the alternative minimum tax. Therefore, it’s best to clarify your tax status in advance.

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