Nothing can be truer than Ben Franklin's quote, "In this world nothing is certain but death and taxes." Looking past the morbid side of that statement, higher taxes are almost certainly coming in the next few years, regardless of who is in office, as local counties, states and the federal government all look to fill their dwindling coffers. Examples can be found in a wide range of states. Kansas could see its unemployment fund exhausted by the end of the first quarter and Virginia is hiking taxes to replenish its unemployment fund to the tune of $1.3 billion. The money problems of our own federal government are well known, congress is facing pending a deficit of around $1.4 trillion.

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Taxes Taxes Taxes
Even with 2010 being an important election year, there's a good chance that congress will let the Bush administrations tax cuts expire at the end of the year. That would see the top earners bracket of 35% move upwards to the pre-cut rate of at least 39.5%. Those in lower tax brackets could see their marginal rates rise as much as 3 to 4%. This doesn't include the potential repeal of the preferred treatment of stock dividends and capital gains rates. Combine all this with a new national sales tax rate record of 8.629% and you have recipe for some real decreases in consumer spending.

Skip the Tea Party
As one of the best ways investors have in fighting taxes, municipal bonds should be a serious portfolio contender. The bonds main appeal is the tax free income. Munis are exempt from federal taxes as well as state tax in the state of issuance. By contrast, Treasuries are only free from state and local taxes. Generally investors in the top three tax brackets will do better in municipal bonds rather than buying a similar treasury issue and paying the tax.

Taxes free income aside, municipal bonds also have an interesting ace up their sleeves. Thanks in part to recent government action, they are getting harder to find. Build America Bonds (NYSE:BAB) were created during the much ballyhooed stimulus plan as a way for local and state governments to raise money quickly and cheaply in order to create more jobs and improve infrastructure. State issuers of these bonds receive a subsidy from the federal government for 35% of the interest, making them cheaper from an issuer point of view. The Build American Bond program is scheduled to end in December of 2010. In the mean time many states are issuing long term (25 to 30 year) bonds, taking advantage of the interest break. The rush of new Build America issues is chocking the supply of traditional tax free munis. (Learn more about BABs in Build America Bonds: Should You Buy?)

Buying the Keys to the City
Exchange traded funds may it easy for investors to add municipal bonds to a taxable portfolio. Just as with regular corporate bond investing, a broad diversification strategy works best when it comes to munis. With nearly $2 billion in assets, the broad iShares S&P National AMT-Free Muni (NYSE:MUB) may be all investors need to add munis to a portfolio, but investors can create a custom portfolio if they desire. For example iShares recently unveiled custom maturity muni bond ETF's ranging from iShares 2012 S&P AMT-Free Municipal Series (NYSE:MUAA) to iShares 2017 S&P AMT-Free Municipal Series (NYSE:MUAF). Investors wanting a quick one-two-three approach can use the following three ETFs and adjust their weightings accordingly to income requirements and risk tolerances.

Rising interest rates can wreak havoc on munis, just as easily as all other bonds. Playing the short end of the spectrum is prudent as the government is expected to raise rates. The SPDR Barclays Capital Short Term Muni (NYSE:SHM) is the most active fund in this area. The funds short term holdings will help cushion against rising interest rates.

Having the least exposure to troubled California and New York (25% of assets) of any muni ETF, the Market Vectors Intermediate Muni ETF (NYSE:ITM) makes a compelling choice for the core holding in a muni portfolio. The MUB currently holds 36% in those two states. ITM offers overall broader exposure, and therefore, less risk than MUB or SPDR Barclays Capital Municipal Bond (NYSE:TFI).

Investors wanting to take a look at the lower end of the quality spectrum can choose the Market Vectors High-Yield Muni ETF (NYSE:HYD). The fund currently yields a tax free 5.5% and offers a way to boost their income portion of the portfolio.

Bottom Line
With states and the federal government facing record deficits higher taxes are almost guaranteed. By investing in municipal bonds now, investors can lower their tax bill and prepare themselves for the upcoming crunch. Exchange traded funds make adding munis to a portfolio easy.

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Tickers in this Article: MUB, HYD, ITM, SHM, BAB, MUAA, MUAF, TFI

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