You have to pay taxes on the income produced by most of your investments, including mutual funds, regardless of whether this income is in the form of capital gains, interest or dividends. Some mutual funds specialize in investing in tax-exempt securities such as municipal bonds, passing the tax savings on to the fund's shareholders. Whether a tax-exempt mutual fund is better than a taxable fund depends on your tax situation.
It's not how much you make but how much you get to keep that determines the best mutual fund for your investment portfolio. When comparing two funds, if everything else is roughly equal, you should consider both funds' tax-equivalent yield. The tax-equivalent yield is the amount a taxable fund would have to produce to equal the yield on a nontaxable fund after you pay taxes. The tax-equivalent yield varies based on each investor's income tax bracket. The higher your income tax bracket, the higher the taxable yield must be to compete with the tax-exempt yield.
Objectives and Risk
When comparing taxable and tax-exempt mutual funds, you should take into account each fund's management, security portfolio and investment objectives. The best mutual fund for your portfolio is also the one that most closely matches your investment objectives and temperament. Whether a fund's portfolio focuses on taxable or tax-exempt securities will typically be only one factor in your overall investment picture. You should additionally examine how much risk the fund's management takes, fund expenses, total return on investment and any sales charges or redemption fees the fund charges.
Apples to Apples
Compare taxable and tax-exempt funds on an apples-to-apples basis to find the one that best meets your needs. Tax-exempt mutual funds typically invest in municipal bonds because the interest on those securities is exempt from federal income taxes. Compare the yield from these types of funds to taxable bond funds that invest in similarly rated corporate bonds. Just because a bond is issued by a municipality doesn't mean it is a safe investment. Municipal bonds that are rated below investment grade by a ratings organization such as Moody's or Standard and Poor's involve significant risk of default but might pay a higher-than-average interest rate.
Qualified retirement accounts such as your 401(k) or individual retirement account offer tax-advantaged growth on the investments held in the account. Withdrawals from some qualified accounts, such as traditional IRAs, are taxed as ordinary income, regardless of how the funds in the account were earned. If you put a tax-exempt fund in your traditional IRA, you'll lose the tax benefit when you start taking withdrawals. Since taxable mutual funds typically produce a higher rate of return than comparable tax-exempt funds, you're usually better off going with the taxable fund for your retirement money.
Few tax-exempt mutual funds produce only tax-exempt returns. While the interest on a municipal bond held by the fund is exempt from federal income taxes, it might be taxable at the state and local level. If the fund sells a municipal bond before its maturity, it might incur a capital gain or loss, which will be passed on to the shareholders. Capital gains are taxable on your federal income tax return.
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.