Question: Municipal bond funds pay about 11 percent tax-free, equivalent to 16 1/2 percent taxable income for people in the 33 percent tax bracket. How safe are these funds? With Mr. Reagan's new federalism is it possible that cities will have such large obligations that they may default? They seem to be such fantastic investments that we wonder why knowledgeable people would buy anything else.

Answer: There always has been some risk associated with municipal bonds; and that risk is likely to increase with any transfer of costly public functions from federal to local government responsibility.

I consider the risk moderate if you stay with a fund that invests only in high-quality investment-grade bonds. Every potential investor should read the prospectus carefully to learn what the fund's investment policies are.

The very use of a fund rather than investing in individual municipal bonds tends to reduce the risk a little by virtue of the broad diversification in the fund portfolio.

Why doesn't everyone buy municipal bond funds? Because not everyone has the same investment objectives -- and different investment vehicles are needed to meet different goals.

Not every one is in the 33 percent tax bracket; and people in lower brackets may still have money to invest. Example: a 70-year-old widow with only social security plus the income from $100,000 in insurance proceeds will end up in the 21 percent tax bracket next year, and has no business in municipals.

With a portfolio invested in fixed-income securities, a bond fund offers little opportunity for long-term appreciation. Young people should be investing primarily for growth rather than income -- even tax-free income.

And "tax-free" refers only to federal income tax. Residents of states with high state/local income tax levels may do better buying individual issues in their home state, even though they give up diversification.

Municipal bond funds have a place in many investment portfolios, but they're not for everyone. And even for those who can use these funds, the percentage of total assets committed in this area will vary with the individual.

Q: Would you please comment on the situation where an estate owned U.S. Series E bonds listed in the federal estate tax return at a value that included accrued interest to the date of death. When the bonds are distributed to the heirs, it would seem only the interest earned after the date of death would be taxable to the heirs upon redemption, since estate tax was paid on the interest up to that date.

A: You're correct as far as the heirs are concerned. They incur income tax liability only on interest earned after the date of death.

From the point of view of the estate, however, merely including the bonds with accrued interest on the estate tax return does not satisfy the income tax liability.

If the decedent had been deferring the reporting of the Series E interest each year, then all of the accrued interest up to the date of death must be included as income on the decedent's final income tax return.

If he or she had been reporting the interest income annually, then the final return should include only the interest accrued from the last day of the previous year's tax return to the date of death.

This situation -- involving earned interest not yet reported -- is different from an asset with unrealized appreciation. In the latter case an heir picks up the estate tax valuation as the new cost basis without any income tax accountability arising on the part of the decedent.

It is the responsibility of the executor of the estate to sort out these various pieces of the tax puzzle, and to determine what belongs on the estate tax return and the final return of the decedent and what must be picked up by the heirs.

This is one of the many potential problem areas requiring special knowledge and research resources. It is a good example of why I recommend careful selection of a qualified executor when drawing your will -- and why a nonprofessional executor should get professional help.