Never let the tax-planning tail wag the investment-strategy dog. That's one of those little bits of advice we offer readers again and again, but the recent reduction of the dividend tax makes now a good time to repeat the ol' adage.

Ever since President Bush floated the idea of eliminating dividend taxes, financial experts have been fretting about the demise of the municipal bond market. The thinking goes that since returns on dividend-paying stocks are better than the yields on munis, investors would be seduced into taking their money out of city, county and state notes.

The three-week-old tax law doesn't eliminate dividend taxes, but it does trim the maximum rate dividends can be taxed to 15%. Even if you're in the 35% tax bracket, though, that's no reason to dump munis.

Diversification, taxes and more taxes

You need to stay diversified, financial experts agree. The portion you invest in municipal bonds is "sleep at night money," says Jane McCart, portfolio manager at Northern Trust. Munis are less risky, less volatile and generate more income than stocks. (For more on municipal bonds, see Making Money With Municipals.)

"Stocks may make you rich," says Meier Statman, professor of Finance at Santa Clara University, "but bonds keep you from being poor."

The interest earned from them is also exempt from federal income tax and, in most cases, from income taxes of the issuing state as well. (The only exceptions are Illinois, Iowa, Kansas, Oklahoma and Wisconsin, which limit exemptions.) And the new tax laws may also indirectly make these tax advantages more beneficial, too.

State governments are facing budget shortfalls of $70 billion to $85 billion for the coming fiscal year. The recently enacted tax cuts will reduce the amount of federal dollars rolling into state coffers by an additional several billion dollars. In an effort to balance their budgets, 25 states have requested or enacted tax increases. So far, five governors, including those in California and Pennsylvania, have proposed higher personal income taxes, particularly for high-income families. This will make the state-tax exemption for municipal bonds even more valuable for their residents.

Muni bonds today offer attractive yields. On average, they are just below comparable Treasury rates, but Treasuries aren't federally tax-exempt (they are state tax-exempt, however). Most investors should invest via a mutual fund rather than buying individual municipal bonds. A fund provides professional management and a diversified portfolio, and monthly or quarterly payouts at a low initial cost. The following muni bond funds offer excellent records and low expenses.

Five solid funds

Harris Insight Tax Exempt (HXBAX) and Harris Insight Intermediate Tax Exempt (HIXAX). George Selby employs a four-pronged process to fill theses portfolios. First, he decides which part of the yield curve is most attractive, and then determines which sectors to emphasize. Security selection and risk control are the last part of the process.

These no-load funds require only a $1,000 investment. Expenses are about half that of the average municipal bond fund and both funds have outperformed 90% of their peers over the past five years. The 30-day yields are 3.1% and 3.8% respectively for the Intermediate and Tax-Exempt funds.

Northern High Yield Muni (NHYMX). Because it invests in so-called junk muni bonds, Northern High Yield Muni yields 4.8% or a tax-equivalent yield of 6.4% if you are in the 25% bracket. To avoid defaults and maintain adequate liquidity, portfolio manager Jane McCart buys higher quality bonds (16% of the portfolio is A-rated) and avoids risky offerings despite their stratospheric yields. "Diversification is key," so no single bond is worth more than 2% of the portfolio of 75 to 80 bonds. You can invest in this no-load fund, which has outperformed 80% of its peers over the past three years, for $2,500.

Vanguard Long Term Tax-Exempt (VWLTX) and Vanguard Insured Long Term Tax Exempt (VILPX). Extremely low expenses (0.17%) give an edge to these funds. Average maturity is 15 years, which Reid Smith, manager of the Insured fund, considers the optimal term to invest in now. Current yields for these no-load funds, which require a $3,000 initial investment, are 3.1% for the insured fund and 3.3% for the long-term fund. Both funds are in the top 10% of their category for the past three, five and ten years.

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