How to Invest in Tax-Free Bond Funds

Tax-free interest is still reportable when you file your tax return even if it is not taxable.

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One of the big advantages of investing in municipal bonds is their tax-free interest, which can make a big difference if you are in a high income tax bracket. You can buy individual municipal bonds, or you can spread out your risk by investing in a tax-free bond fund. Tax-free bond funds invest in a portfolio of a lot of different municipal bonds, giving you a piece of each bond in the portfolio.

Step 1

Determine your investment goals and temperament. If you are interested in investing in a tax-free bond fund, tax-exempt interest income is probably at least a part of your objective, but it might not be the only part. You might also be interested in opportunities for capital gains. You might be willing to give up some safety in exchange for a higher interest rate, or you might want to sacrifice income for a higher degree of safety.

Step 2

Research your investment options. Just as thousands of individual municipal bonds are on the market, a multitude of tax-free bond funds are available, and each has its own objective and composition. Match your investment goals and temperament to tax-free bond funds that have similar investment objectives. Once you find a fund that looks like a potential match, contact the fund's investor relations department and request a prospectus. The prospectus includes specific information regarding the fund's investment objectives, investment strategies, fees and expenses, risks and past performance history. This will help you make an informed decision.

Step 3

Make your investment. Unlike stocks or bonds that are traded on the open market, mutual fund shares are purchased from the mutual fund company once per day at the fund's net asset value. Different tax-free bond funds have different methods for selling their shares. Some go through sales representatives or investment brokerage firms, while others allow investors to buy shares directly from the mutual fund. You will likely have to complete a new account application, which will require certain personal information, such as your name, address, Social Security number and contact information. The fund will want to know how to handle dividends and capital gains distributions. You can usually have those funds paid to you or reinvested into additional shares.

Tip

  • Consider any sales charges on your mutual fund shares. Some funds charge a front-end load, or sales charge, while others charge a redemption fee, or back-end load. Some funds, called no-load funds, don't have a sales charge, so more of your money goes into buying shares rather than paying commissions.

Warning

  • While the interest passed through to you from municipal bonds held in the fund are typically free from federal income taxes, any capital gains that might result from sales in the fund are not tax-exempt. Some of your distributions might be taxable when you file your federal income tax return.

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About the Author

Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.

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