Tax-Free Income Funds: Are They Right for You?

Investing in a tax-free income fund is attractive for many different types of investors. However, this type of investment is not suitable for everyone. Here are the basics of the tax-free income fund, including information to help you determine whether it would be a good investment for you.

Tax-Free Income Funds

A tax-free income fund is a mutual fund that provides a regular monthly payment to you without any requirement of taxation on the returns. This tax-free income is produced by investing in municipal bonds from a number of different types of organizations. Municipal bonds are provided by state governments, city governments, school systems, airports and many other types of municipalities.

How They Work

This type of mutual fund will pool together the assets of many different investors. It will then use this money to purchase many different municipal bonds from a variety of sectors. The mutual fund then becomes a creditor to all of the municipalities that issued bonds to them. As a result of this, the municipalities will make monthly interest payments to the mutual fund. The monthly payments are designed to address only the interest on the loan. The principal will remain with the municipality until the term of the bond has been satisfied. The mutual fund collects all of the monthly interest payments from the collection of municipal bonds in which they have invested. The interest payments are then divided equally among all of the shareholders in the fund. The investors are then allowed to keep this money without paying any taxes on it.

Investment Considerations

While the idea of getting tax-free money might seem very attractive, it may not be as good as you think. Because of the extra tax incentive, these municipalities will not pay a very high rate of return. Therefore, you could potentially make more money with a traditional mutual fund even if you have to pay taxes on your gains. In order to determine if this type of investment makes sense for you, you will need to look at your marginal tax rate. With this information, you will be able to accurately assess whether tax-free income funds will be better for you than other investments.

Example

In order to understand how this works, here is an example to illustrate what you need to consider. Let's say that you had two different mutual funds that you could invest in. One fund is a tax-free income fund. The other is an equity fund that invests in stocks. By investing in the tax-free income fund, you would make $1000 over a certain period. During that same time, you would make $1300 by investing in the equity fund. You would get to keep the entire $1000 from the tax-free income fund. However, you would have to pay taxes on the $1300 that you receive from the equity fund. If you are in the 35 percent tax bracket, you would have to pay $455 in taxes. This means that only $845 of that money would be profit. Therefore, even though the equity fund has a higher rate of return, you will be able to come out ahead with the tax-free income fund.