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How Tax Free Mutual Funds Work


Investing in a Tax-free Mutual Fund
A financial adviser from The Enchantment Group in Miami offers advice to a client. A financial adviser can help with your decision on tax free mutual funds.
A financial adviser from The Enchantment Group in Miami offers advice to a client. A financial adviser can help with your decision on tax free mutual funds.
Joe Readle of Getty Images News

Any investor would find tax savings on investment income appealing. However, before making any investment, you need to know your investment goals. Here are a few questions you might want to ask yourself:

  • Do you want to provide income for your children's education?
  • Do you need to save for your retirement?
  • Do you want to travel?
  • Do you want to buy a home?
  • How much risk do you want to assume in your investments?

Discuss such questions with a financial adviser, accountant or other professional. You will then be able to decide if investing in a tax-free mutual fund can help you meet those goals.

There are advantages and disadvantages to tax-free mutual funds. On the plus side:

  • Tax savings on income. Taxes can eat up a significant portion of investment profits.
  • Low risk. Your investment is relatively safe, since municipal bonds are backed by the government body that issues them.
  • Liquidity. You may sell all or part of your investment at any time because your investment is in a bond fund instead of an individual bond. Here's why: The bond fund will pay you according to the per-share value of its investments at the time. On the other hand, if you owned an individual bond, you would have to wait until the bond matures to sell or find someone else to purchase the bond from you.

The most significant disadvantage to investing in tax-free mutual funds is a lower return on your investment. Municipal bonds have lower interest rates because they are tax-exempt. These lower interest rates mean a lower yield than you might expect to receive from investments in other types of mutual funds. However, wealthier investors in a higher tax bracket may find their lower returns offset by the tax savings.

Another downside to investing in tax-free funds is the fees and other expenses the fund charges to manage your investments and market the fund to potential investors. These charges are common to mutual funds of all kinds. However, due to the lower yield on tax-exempt bonds, these fees eat up a greater percentage of income than investments with a higher rate of return.

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A mutual fund's prospectus can help you choose a fund. Armed with this data, you can make an informed investment choice.

If you'd like to know more about tax-free mutual funds and related topics, you can follow the links on the next page.


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