Image: Recon Cycles, Flickr

If you're looking for tax-free bonds, you need to look at municipal bonds. Yes, bonds issued by the federal government are tax-free at the state and local level, but they're not exempt from federal taxes. Municipal bonds, though, are generally exempt from taxation at the federal level, and when bought from in-state issuers, they can be free from state and local taxation, too.

The case for municipal bonds
At first glance, municipal bonds might not seem like the best investment. After all, per the research of finance professor Jeremy Siegel, stocks outperformed bonds in 96% of all 20-year holding periods between 1871 and 2012, and in 99% of all 30-year holding periods. And even among bonds, municipal bonds don't generally offer the highest yields.

Still, it's smart to hold some of your assets in bonds, for diversification. And municipal bonds' lower yields are offset considerably by their tax-free nature. Income from taxable bonds is taxed at your ordinary income rate, which approaches 40% for the very wealthy and is probably around 25% or 28% for the rest of us. That's a big difference from the long-term capital gains tax rate of 15% that most of us face. The fact that municipal bonds are generally tax-free can be a big deal for those in upper tax brackets.

It's smart to diversify your portfolio with some bond holdings. Image: PT Money: Personal Finance.

Choosing the best municipal bonds
There are two key kinds of municipal bonds: general obligation bonds, or GO bonds, which are backed by the municipality that issues them, and revenue bonds, which are funded by expected revenue from various projects (such as toll roads, stadiums, or hospitals), and which are therefore generally less safe than GO bonds. Revenue bonds sometimes buy insurance in order to lower their risk, reassure investors, and perhaps increase their ratings. If you're considering a bond, check to see if it's insured -- and look into the credit-worthiness of the insurer, too.

When evaluating bonds, be sure to look for a strong credit rating from a major agency such as Standard & Poor's, Moody's, or Fitch. With Standard & Poor's and Fitch, the best rating is AAA, with AA+ AA, and AA- also being very good. With Moody's, the top rating is Aaa, with Aa1, Aa2, and Aa3 also being very strong. For maximum security, stock with these ratings. Bonds with lower ratings are likely to offer higher yields, but they also carry greater risk.

It's also smart to stick with bonds from larger municipalities, as they can be easier to resell if you need or want to. And, not surprisingly, for greatest security, avoid bonds from regions that are struggling economically, such as Detroit or Nevada. Finally, be sure to double-check that a presumably tax-free municipal bond in which you're interested is actually tax-free, because a small minority are not.

If you're not entirely comfortable selecting municipal bonds on your own, perhaps opt for a low-cost mutual fund or exchange-traded fund focused on them. (ETFs will generally sport lower fees.) Some solid choices include the Fidelity Intermediate Municipal Income Fund (FLTMX), the T. Rowe Price Summit Municipal Intermediate Fund (PRSMX), the Vanguard High-Yield Tax-Exempt Fund (VWAHX), the iShares National AMT-Free Muni Bond ETF (NYSEMKT: MUB), and the Market Vectors High-Yield Municipal ETF (NYSEMKT: HYD).

Photo: Got Credit

10 best states and cities for municipal bonds
If you are interested in investing directly in some individual municipal bonds, following are 10 that recently were deemed safest by the folks at All 10 are general obligation bonds with AAA ratings.

  • Williamson County Texas Unlimited Road Tax Road Bonds Series 2007, with a 4.75% interest rate and long-term February 15, 2032 maturity date.
  • City of Arlington Texas Water and Wastewater System Revenue Bond Series 2007, with a 5% interest rate and short-term June 1, 2017 maturity date.
  • Harrison County Flood Control Improvement Bonds Series 2007, with a 5% interest rate and long-term October 1, 2031 maturity date.
  • Central Utah Water Conservancy District GO Refunding Bond Series 2004, with a 5% interest rate and medium-term April 1, 2021 maturity date.
  • City of Virginia Beach Virginia GO Public Improvement Bonds Series 2005, with a 5% interest rate and medium-term January 15, 2021 maturity.
  • City of Minneapolis Minnesota GO Improvement Bonds Series 2002, with a 5.25% interest rate and December 1, 2026 maturity date.
  • Polk County Iowa GO Bond Series 2006B, witha 4.1% interest rate and near-term June 1, 2017 maturity date.
  • Des Moines Iowa GO Refunding Bond Series 2005E,with a 4.5% interest rate and June 1, 2020 maturity date.
  • State of Tennessee GO Bonds 2003 Series A, with a 5% interest rate and short-term August 1, 2018 maturity date.
  • Oklahoma City Oklahoma GO Refunding Bonds Series 2005,with a 5% interest rate and short-term September 1, 2018 maturity date.

If you're looking for low-risk investments with growth potential, give tax-free municipal bonds some consideration. They're especially helpful for those in the top tax brackets.