Financial advisors may want to turn high-net-worth clients on to municipal bonds to generate tax-free income.

Muni bonds are debt securities issued by a state, municipality or county to finance its capital expenditures. Muni bonds are exempt from federal taxes and from most state and local taxes, especially if investors live in the state in which the bonds are issued.

Muni bonds are a great option for high-income taxpayers who may be subject to the 3.8% net investment income tax, the highest income tax bracket of 39.6% or live in a high-income tax state such as California or New York, says Anjali Jariwala, founder of FIT Advisors in Chicago.

“In general, interest from bonds are taxed at ordinary income tax rates, unlike stocks which pay out dividends that are taxed at lower capital gains rates,” she says. “Municipal bonds are a great option to mitigate the potential tax hit from bonds.”

For example, if a client is in a 35% federal tax bracket and is considering a muni bond with a 5% yield, the client would have to earn a taxable yield of 7.69% to match the yield of the muni bond.

“If you reside in a high-income tax state, you can get a double benefit by purchasing bonds in a state you reside in,” Jariwala says. “For example, if you live in California and purchase California municipal bonds, it will be both federal and state tax-free.”

One thing that advisors should tell clients to watch out for is the alternative minimum tax, Jariwala says.

Private-activity muni bonds, which are normally used to fund stadiums hospitals or other local projects, are generally free of ordinary income tax, but the income is included for AMT purposes. If a client is deciding to purchase a private-activity bond, the AMT considerations should be taken into account to avoid a potential pitfall.

Very often corporate bonds are the better choice, says David D. Holland, chief executive and certified financial planner at Holland Financial in Ormond Beach, Fla.

“Let’s say a corporate bond is paying 4% and a tax-free municipal bond is paying 3%. If a client is in the 15% tax bracket, they are better off paying 15% on a 4% corporate bond, which is 3.4% net, versus getting 3% on a municipal bond,” Holland says.

“The only time it makes sense to own a municipal bond is when a client has very high taxable income and is in the highest tax brackets,” he says.

Katie Kuehner-Hebert is a freelance writer in Running Springs, Calif. She has contributed to American Banker, Risk & Insurance and Human Resource Executive.

This is part of a 30-30 series on tax planning strategies.