Since the development of the federal tax system authorized by the Sixteenth Amendment to the Constitution in 1913, the federal government has chosen not to directly tax the income from such bonds. Within the American legal and political tradition, it has been thought that taxing the interest on municipal securities would be a burden to state governments and interfere with the state's ability to borrow money. The Tax Reform Act of 1986 continues the basic exemption from direct taxation for interest on municipal securities set forth in the Internal Revenue Code.

If you purchase a bond issued in your state of residence, you do not have to pay state income tax (if there is one). In some cases, you may even be exempt from local income taxes, as well. Residents of the City of New York, for example, are exempt from city, state and regular federal taxes on income earned from in-state issued bonds.

Today, the widespread appeal of municipal bonds is proven by the fact that approximately 70%* of municipal securities (including those held through unit investment trusts and mutual bond funds) are owned by individual investors. There are several reasons why tax-exempt municipal bonds can be an attractive and solid investment:

* Federal Reserve Flow of Funds Report, 1998.
** Some bonds may be subject to the Alternative Minimum Tax (AMT).

The following example illustrates: If a New York state resident were to purchase $10,000 worth of a 7% corporate bond and was in the 6% state tax bracket and the 28% Federal tax bracket, he would have to pay 32.93% (the Combined Effective Rate), or $238, to state and federal tax authorities. This would leave him with an after-tax yield of 4.62%. Thus, a 5% New York municipal bond that is both free of federal and state taxes and yielding more than 4.62% would be an attractive alternative.

Compare the Taxable Equivalent Yield (TEY) of municipal bonds to the yield of similar maturity, similar quality taxable bonds (CDs, U.S. Treasury bonds, corporate bonds). Taxable Equivalent Yield is the yield an investor would have to earn from a taxable security to equal the value of a tax-exempt security of the same credit quality.

Consider this example:

Mr. Abbott, Ms. Brown and Mr. Cooke each have $100,000 available for investment in high quality, market-name securities. Essentially, these are the characteristics of high quality bonds. Each investor had equity and other asset holdings.

Potential fixed income alternatives include a 20-year maturity "Aa"-rated municipal bond yielding 5.00% and a similarly rated long-term corporate bond offering a return of 6.50%. As par-priced securities, the bonds would earn annual income of $5,000 (tax-exempt) and $6,500 (taxable) per year, respectively.

The value of the taxable corporate bond’s annual income for each investor is calculated as seen in the preceding table. Each investor would realize $5,000 in income from the tax-exempt bond. Mr. Abbott would be better off investing in the municipal investment, since his net return would be $4680 vs. $5000 from the tax-exempt bond. Ms. Brown’s tax-exempt return of $5,000 marks the municipal bond as a better choice than the corporate bond, with its net return of $4,355. The municipal is even more attractive for Mr. Cooke, since the taxable alternative nets only $4,225, after taxes.

The 2003 Federal Income Tax table is another way for each investor to look at the relative value of tax-exempt investment. For Ms. Brown, a better return than 5.00% tax-exempt (33% bracket) would require a taxable bond yielding more than 7.46%; for Mr. Cooke, the taxable bond’s yield would have to exceed 7.69%. To attain such levels- if indeed it is possible to attain such levels on an investment quality security- may require lowering quality standards or extending maturities on the taxable bond purchase.

No, you should consider several other factors, including the credit quality and maturity ranges of the bonds you will invest in, call features, your tolerance for risk and your investment goals. You should also speak to your tax advisor before making any tax-related investment decisions.

Bonds are categorized as short-term, intermediate-term or long-term. This table depicts the usual characteristics of each. Individual bond and market conditions may vary.

* Market prices at the time of sale may be more or less than the original investment, or maturity value, depending on prevailing market conditions. Liquidity on all municipal bonds may vary depending on a particular bond's credit quality and market conditions, among other things.