A common way that people have the chance to earn a tax free rate of return is through municipal bonds. This is different than a tax deferred investment, which enables you to pay the taxes down the road such as when you sell it or when you start taking withdrawals (like with a Traditional IRA). Currently there is no limit to how much you can put into municipal bonds. The yield that you get from the bonds can be completely tax free - unless you are subject to the Alternative Minimum Tax (AMT). Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply. Municipal bonds may not be suitable for all investors. Please see your tax professional prior to investing.
The catch with municipal bonds is that, as with nearly all bonds, the day-to-day price can fluctuate up and down. If you sell it along the way, that growth or loss in price will be treated as a normal capital gain or loss and you'll pay taxes on it (or write it off as a loss if you are able) - more on price fluctuation in a minute. And just to note, this information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
First of all, what is a municipal bond? A municipal bond (or "muni bond") is a fractional share of public debt that is issued from some municipality. This could be a bond issuance to build a new convention center in Baltimore, MD or an airport in Duluth, MN, or a water works project in St. Louis, MO. It could be for a highway, school system, utility, etc. The actual municipality could be a city, county, or any other municipal jurisdiction (such as parks and recreation centers). They are government political subdivisions within a state that get their funding through tax dollars. They're different from Treasury Bonds in that treasury bonds come from the federal level and the yields are only tax free at the state and local levels.
Because of the taxing powers of the issuer of the bonds, municipal bonds are generally considered low risk. "Low risk" speaks primarily from a standpoint of, "Are they going to pay me back?" versus any assessment of price fluctuation. Naturally, this is just the tip of the ice berg. Municipal bonds come in all shapes and sizes with differing maturity lengths and where their revenues come from. The lowest of low risk muni bonds are going to be issuances for general obligations. Other bonds can be issued with a specific risk than can go up as the project goes over budget. A good example of this was when Denver International Airport was being built. This municipal project notoriously exceeding its budget. As this happened, they had to issue more muni bonds to finish up the project. Because of this, the perceived risk of default went up (and likewise the municipality had to offer higher yields to bond buyers in order to raise the money) - typically, higher risk bonds come with higher yields. Also you can get unusual municipal bonds. A municipality can raise money for a project by issuing bonds, but say that they plan to use money that they are receiving from a settlement (such as from a tobacco company) to pay the bond payment. Because of the structure of these "Tobacco Bonds", they can receive a riskier rating - however, it's important to note that even if the tobacco company ceased to pay their settlement, the municipality is still on the hook for the payments. It goes on and on. This does not mean than muni bonds cannot be defaulted on or that you are protected against loss.
Historically municipal bonds have a very low default rate, particularly among bonds rated BBB or higher. Default is when a bond payment is one or more days late. Those worried about it can diversify their risk of a bond defaulting by buying many different municipal bonds.
As I mentioned earlier, even though municipal bonds continue to pay interest, their price can fluctuate for various reason and often for reasons that don't directly relate to the municipalities themselves. In 2008 they began a long decline in price. That decline had several causes. One was that investors had large municipal bond positions along with their various other holdings. When those other holdings (perhaps it was real estate or stock options) were virtually wiped out of their value as the markets went down, the investors were getting margin calls forcing them to sell out their positions and to send them their money. At that point some of the holdings that still had value were the municipal bond positions and the investors were forced to sell them. Multiply this across many investors and you have lots of people selling. In any situation where you have more people selling than buying, prices are going to go down. This price drop bottomed out in early 2009 and prices quickly rebounded, particularly as people who had panicked out of the market were buying bonds in general (not just municipal bonds).
However, in the fall of 2010 Meredith Whitney (who had been very right about predicting the financial crisis) very publicly and vehemently predicted that municipalities were going to see hundreds of billions of dollars their bonds go into default in 2011. This was a very dire prediction considering the biggest default year on record was $8.2 billion. This caused a lot of fear and once again we had more sellers than buyers and municipal bond prices took a big tumble. Starting at the beginning of 2011 up to the present day their prices have recovered rather briskly (Source: The Great Financial Crisis: Causes and Consequences, John Bellamy Foster and Fred Magdoff).
I think municipal bonds are soon to come back in vogue. They've had a very rough four years (I believe their roughest, ever) and mostly because of forces outside of themselves. In this environment they're far too attractive for investors to pass up and it's just a matter of time before the public picks up on this.