Dec. 31, 2012… Mark it on your calendar.

On that day, the “Bush era” tax cuts are set to expire.

If Congress decides not to renew the cuts, then starting in 2013, the dividends you receive from your income investments will be taxed at your marginal tax rate, rather than the reduced 15% rate income investors have enjoyed for the past nine years.

#-ad_banner-#While there’s no telling how this situation will pan-out in Congress, if the prospect of higher-taxes keeps you up at night, then you do have some options.

There is still one asset class that offers steady dividends, above-average yields and better yet… the distributions you receive from these investments are 100% tax free.

I’m talking, of course, about municipal bonds.

Municipals bonds or “munis” are a unique asset class. Like treasuries, munis are issued by the government. But instead of coming from the federal government, these bonds are issued by local municipalities like cities, counties and public utility districts.

Historically, the U.S. government feared that taxing municipal bond distributions would hurt a state’s ability to raise money. As a result, muni investors don’t have to pay taxes on the interest payments they receive.

Generally speaking, these bonds come in two forms. There are general obligation bonds — bonds that are backed by the taxing authority of the municipality. And there are revenue bonds — bonds are backed by fees such as tolls or utility rates.

These dependable income streams are the primary reason municipal bonds have historically had much lower default rates than corporate bonds.

Prior to 2009, the default rate for non-investment grade municipal bonds was 2.7%… versus a default rate of 19.1% for similarly rated corporate bonds.

That trend has broken down during the past couple of years. Because of the depressed property values and larger pension bills brought on by the great recession, some municipalities have struggled to pay their debts recently.

In 2010 and 2011, municipal bond defaults rose to 5.5%, higher than their historical average of 2.7%. As a result, buying a single municipal bond looks risky right now…

But municipal bonds still have their advantages. And if tax-free income sounds like something you’re interested in, then a bond fund like PowerShares Insured National Municipal Bond Portfolio (NYSE: PZA) could be worth your while.

By holding a portfolio of municipal bonds, a fund can minimize the effect of any single bond that may go into default. As a result, an exchange-traded fund (ETF) like PZA gives you all the advantages of owning individual muni bonds, but without a lot of the risks.

And if the added diversification wasn’t enough to make PZA attractive, then there’s another reason to like this fund right now.

To get a more favorable credit rating, municipal bond issuers can buy insurance. These insurance policies pay interest to bondholders in the event the issuer defaults.

Most of the companies that issued municipal bond insurance were the same companies that issued mortgage insurance during the housing bubble. After the bubble burst, many of these insurers went bankrupt or left the business.

With so many companies exiting the insurance space, it’s hard to find insured muni bonds right now… which is why I like PZA. PZA tracks an index of insured municipal bonds. All of its rated bonds have an investment-grade rating of “A” or above.

Right now, PZA pays a monthly dividend of $0.09 per share. At today’s share price of $25.58, PZA is currently offering a 4.2% dividend yield. And if the “Bush-era” tax-cuts aren’t renewed at the end of this year, then the yield will actually be a lot higher since the interest payments are tax-free.

Municipal bonds are one of the few asset classes that offer tax-exempt income. And unless Congress gets its act together that will become an even bigger benefit come Dec. 31.

Action to Take –> Municipal bonds will likely see higher historical default rates in the foreseeable future. But a fund such as PZA — one that holds a large number of insured municipal bonds — can help minimize your risks and your taxes.

P.S. — If you haven’t done so, you can learn more about my income investing advisory, The Daily Paycheck. In the past year, I’ve collected more than $13,000 in dividends. Learn more about how you can do the same thing by visiting this link.