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How Tax Free Mutual Funds Work

What is a Tax-free Mutual Fund?
Bond dealer Jim Lebenthal sits in front of a sewage treatment plant financed by municipal bonds.
Bond dealer Jim Lebenthal sits in front of a sewage treatment plant financed by municipal bonds.
Suzanne Opton of Time & Life Pictures/Getty Images

There are more than 8,000 mutual funds in the United States. The income from most of these funds is subject to federal and state taxes [source: Investment Company Institute]. However, that is not the case with mutual funds that invest solely in tax-exempt municipal bonds. These funds are called tax-free mutual funds. However, to understand how tax-free mutual funds work, you need to understand how bonds work.

A bond is a type of contract issued by a corporation or a government body. That corporation or government body promises to repay borrowed money on a specified date and to pay interest to bond buyers. The bond's interest is paid periodically, often twice a year, and usually is set at a fixed rate. That means it cannot be changed, as variable interest rates can be.

What are bonds generally used for? A bond is issued to finance day-to-day operations or special projects. It may be a short-term bond, with a term generally under three years, or long-term bond, with a term as long as 20 or 30 years.

Municipal bonds are issued by state, city or local governments. Because these government entities are not subject to federal tax, income derived from investing in municipal bonds is also free from federal taxes. Municipal bonds are usually free from state and local taxes as well, especially in the state where the bond is issued -- but not always. Therefore, you must make sure a municipal bond is free from all nonfederal income taxes before investing. Profits on the sale of municipal bonds may be treated as income. As a result, that income could also be subject to something called a capital gains tax.

Tax-free mutual funds invest only in municipal bonds. These funds use the combined monies of their investors to purchase bonds when they are issued. These bonds then pay interest periodically on the principal and return the full principal on a specified maturity date. Mutual funds continually replace older bonds that mature and make their payoff with purchases of new bond issues.

When you invest in a tax-free mutual fund, you are not investing in an individual bond. You are investing in all the bonds held by the mutual fund and receiving shares in the fund's total investments.

Is it time to invest in a tax-free mutual fund? Be careful, though: There are some potential pitfalls in store for the average investor. Read on to find out if tax-free mutual funds are right for you.