Looking at the tradeoff of bond funds and tax free bond funds. Here are a few facts you should know before buying a bond fund to help you make the best fund choice.

Tax-Free Bonds & Bond Funds
By James Leitz

Municipal bonds (munis) have been around for years and offer investors interest income that is tax-exempt, free from federal income taxes. This is important to many bond investors, because they buy bonds for the higher income they pay vs. CDs and savings accounts. Municipal bond funds invest in munis. Hence, if you buy the fund, you are invested in municipal bonds and receive dividends that are free of federal income taxes.

Municipal bonds are issued by states and local government entities to raise capital (money) for major projects. The U.S. government gives them a break by not levying income taxes on the interest they pay to investors. This makes it easier for the state of Ohio, for example, to sell bonds and raise money. It also allows the state to pay a somewhat lower interest rate than a corporation with a high credit rating would need to pay to attract investors.

When you invest in a municipal bond fund professional money managers manage a diversified portfolio of munis for you. Some fund families offer funds that are double tax-exempt. For example, an Ohio Tax-Exempt Bond Fund would pay Ohio residents dividends free from both federal and state income taxes.

There are three factors you should consider before investing in any muni bond fund. One, your tax bracket. Two, expenses. Three, interest rate risk.

Let’s say that you are in the 25% tax bracket, which means that in 2008 your taxable income was over $65,100. You want to invest $10,000 into a bond fund. You find a high-quality taxable bond fund that will pay 6% in dividends, or about $600 a year. After paying 25% to the IRS, you net $450, or 4.5%. You pay tax on the interest (dividends) whether you receive it or simply allow it to reinvest and buy more shares in the fund.

In the 25% tax bracket, if you can find a muni bond fund that pays over 4.5% tax-exempt, it is to your advantage to invest in it. The higher your tax bracket, the greater the advantage. If your taxable income was over $200,300 in 2008, for example, you were in the 33% or 35% tax bracket. A 6% taxable bond fund would have left you with only about 4% net after taxes.

Second, mutual fund expenses and sales charges only work against the investor. On a $10,000 investment, a 3% sales charge (load) can take $300 off the top, and yearly expenses could be .5% or more per year. Or, if you go with a major no-load fund family, a municipal bond fund investment has zero sales charges, and yearly expenses can be as low as .15% a year.

Third, all bonds and bond funds are subject to interest rate risk. This means that if interest rates go up, the value or price of bonds and bond funds that invest in them will fall.

A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.

Jim is the author of a complete investor guide, Invest Informed, designed for average investors or would-be investors of all levels of financial background and experience. To learn more about investments and investing and his new financial guide go to http://www.investinformed.com

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