What Is a Tax-Free Mutual Fund?

Tax-free mutual funds hold municipal bonds, which can finance government projects.

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As an investor’s income increases, so does her tax bracket. A tax-free mutual fund offers high-bracket investors interest that is free from federal, and often local, taxes. However, any capital gains from a tax-free fund are taxable, just like those of any other fund. Some tax-free funds attempt to minimize trading to avoid realizing capital gains.

Mutual Funds

A mutual fund is a pooled investment in stocks, bonds or some other assets. A mutual bond fund may specialize in particular forms of debt, such as Treasury securities or municipal bonds. The mutual fund company handles the sale and redemption of shares. The price of a share is its net asset value, which is the fund’s assets minus its liabilities divided by the number of shares. A bond fund periodically distributes the interest it earns. Taxable interest is ordinary income, taxed at your marginal rate. The federal government does not insure mutual funds.

Municipal Bonds

Tax-free mutual funds invest in municipal bonds, which can be free of federal and local taxes. For them to qualify for tax-free treatment, proceeds from the issuance of the municipal bonds must benefit the community, usually through long-term capital projects. Municipal bonds issued for private purposes are not tax-free. You must live in the issuing city or state to avoid local income taxes, assuming you live in a location that levies an income tax. Many municipal bond funds therefore concentrate on the bonds of a particular state. High-tax states, such California and New York, are popular venues for municipal bond funds.

Tax-equivalent Yield

You can calculate the tax-equivalent yield of a tax-free mutual fund to compare it with a taxable fund. The tax-equivalent yield equals the tax-free yield divided by one minus your federal tax bracket. For example, suppose you’re in the 28 percent bracket and your tax-free fund pays a 1 percent yield. The tax-equivalent yield is 1 divided by 0.72, or 1.38 percent. That’s how much a taxable fund must yield to equal the after-tax return of the tax-free fund. If you live in a high-tax location such as New York City, you should use the combined federal, state and local tax rates to figure your tax-equivalent yield.

Capital Gains

A municipal bond mutual fund may sell some of its bonds before they mature. If it sells a bond for a profit, it passes the capital gain onto shareholders. Mutual funds don’t pay taxes as long as they distribute 95 percent of their income to shareholders. A shareholder books her share of a mutual fund’s capital gains as long term, no matter how long she’s held the fund shares. Long-term capital gains qualify for lower rates but usually require you to hold an investment for more than one year. If you sell your fund shares for a gain, the long-term holding period applies.

Capital Gains Rates

The Internal Revenue Service taxes short-term capital gains at your marginal income tax rate. The tax on long-term gains depends on your modified adjusted gross income. If your MAGI exceeds $400,000 -- or $450,000 if you are married -- the tax rate as of 2013 is 20 percent. For lower incomes, the long-term capital gains rate is 15 percent if your tax bracket is 28 percent or higher. Otherwise, the gains are tax-free. So, if you are below the 28 percent bracket, all income from a tax-free mutual fund can truly be tax-free.