A Synoptic Guide to the Top Tax-Free Mutual Funds

Introduction

Though a lot of people do not have an understanding of the retailer market function; however, when it comes to mutual funds, this is not the case. Mutual funds are highly popular among the public and retail markets.

In simpler terms, in a mutual fund, a company brings together money from many people and invests it in stocks, bonds, or other assets. The combined holdings of stocks or other assets that the fund owns are known as its portfolio. Each investor in the fund owns shares, which represent a part of these holdings.

A Brief Understanding of Mutual Funds and their Function

 A mutual fund determines the expertise of the company. The general function includes gathering money from many individual investors and using this pool of funds to purchase various financial assets with regulations. But these funds are quite popular because they have several advantages such as:

• Diversification: The invested money and risk are classified into many asset classes.
• Professional Management: The investment gains compensation depending on the fund’s performance.
• Affordability: You don’t need large amounts of money to invest. The costs of purchasing and selling assets are low because you share them with other fund investors.
• Liquidity: It’s easy to convert shares into income.

Mutual funds do not impose limits on investing, allowing them to trade multiple shares, hold a grip on their leveraging power, and share the income benefits. The company invests the funds in a range of securities, bonds and distributes the profits to the investors according to their stakes.

There are four types of investment funds: stock fund, bond fund, balanced, and money market. The stock and bond funds deal with equity and debt markets. The bond funds have a steady income and interest rates. While stock funds are versatile with high-yield and minimal risk, balanced funds are more secure as the bond fund can be modified with medium risk. Further, the money market funds include investments in short-term debt securities, such as Treasury bills and bonds, which are time-sensitive.

What is a Tax-free Mutual Fund?

When a person’s income increases, the tax bracket, and expenses also increase. Therefore, the tax-free mutual funds are quite popular as they offer high-earning investors interest that is free from federal and local taxes. However, in the case of capital gains from a tax-free fund, investors need to pay tax similar to other bond funds.

The function of the tax-free mutual funds is quite often linked to how bonds function. Generally, a bond is a debt investment with which the investor loans money to an entity that borrows the funds for a defined period at a specified interest rate. The interest is paid periodically, often twice a year, and usually is set at a fixed rate. In other words, it cannot be changed, as variable interest rates can. It may be a short-term bond, with a term generally under three years, or a long-term bond, with a term as long as 20 or 30 years.

Investing in the bonds held by the mutual fund allows receiving shares in the fund’s total investments. In a tax-free mutual fund, the investing of income is spread across multiple bonds. The general tax-free income investments include:

• Municipal Bonds: Mutual funds placed in government or municipal bonds, also called munis, are often referred to as tax-free funds because the interest generated by these are not subjected to income tax. These municipal bond funds are issued by the state, city, or local governments.

Many tax-free mutual funds usually invest in municipal bond funds because they are free of federal and local taxes. Once the bond qualifies for tax-free treatment, profits from the municipal bond must help in long-term growth. To avoid local income taxes, one must be a resident of a location that levies an income tax. Certain bonds issued in a state are triple-tax-free, i.e., interest on bond funds can be exempt from all state, local, and federal income taxes. Municipal bond funds issued for private purposes are not tax-free.

• Tax-Exempt Exchange-Traded Funds: Exchange-traded funds are similar to mutual funds, as they provide long-term and short-term tax-exempt bonds, depending on investing goals or expense ratio and trade on an exchange. Like mutual funds, ETFs can also be municipal bond focused, which provides the tax-exempt benefit.

High-yield municipal bond exchange-traded funds usually invest in the debt issued by state or local governments. This municipal bond is designed to raise money for overall growth, such as building public schools, repairing bridges, etc., and tracks the performance of an index that focuses on high-yield municipal bonds through a sampling approach. However, before investing, one has to carefully consider the expense ratio of the bond fund you’re paying to invest in a tax-free ETF.

• Tax-Exempt Mutual funds: The tax-exempt mutual fund is a municipal bond issued by the government that allows investing without paying taxes on the returns. This is a high-yield municipal bond, which is risk-free with tax benefits. Though the mutual fund typically holds stable rates of return and government securities, the tax-exempt fund may depend on market conditions. Hence, traders must be aware of the expense ratio to eliminate investing in free income in management fees.

Tax Equivalent Yield

The tax-equivalent yield is the amount of a taxable fund, which equals the after-tax return to the tax-free income fund. The tax-equivalent yield varies based on each investor’s income. The higher the income tax bracket, the higher the taxable yield must be to compete with the tax-exempt yield or tax-free income.

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, which depends on the interest on the high-yield municipal bond at the federal or local level.

Capital Gains

A municipal bond mutual fund has a limited time period of maturity. Therefore, when the bond is sold for a profit, the capital gain is distributed to shareholders. The capital gains are generally taxable. To avoid this, some mutual funds distribute 95 percent of their income to shareholders. Long-term capital gains qualify for lower tax rates and the expense ratio but usually have a requirement of investment for more than one year. If fund shares are sold for a high-yield, the long-term holding period applies.

ELSS and Capital Gains Rates

The Equity Linked Savings Scheme or Equity Mutual Funds are popular tax saving schemes. They enable the option of tax deduction with added benefits of long term capital gains and tax exemption without minimum expense ratio.

Capital gain rates depend on the Internal Revenue Service (IRS), which assesses short-term capital gains at the marginal income tax rate. The tax on long-term gains depends on your modified adjusted gross income. For lower than average incomes, all gains from a tax-free mutual fund are genuinely tax-free.

Conclusion

Similar to various other high-yield funds, there are certain advantages and disadvantages for these funds, such as:

Advantages

These mutual funds are relatively safe. Federal and local governments issue them with rights reserved, and the high earning investors have an opportunity to invest with lower interest rates and gain returns with tax savings, providing a steady stream of income for the investors.

Disadvantages

The tax saving on the high-yield investment may take up the profits gained and do not have time valuation, i.e., one can sell all or part of the investment made before it matures. Another point to consider is that there are usually lower interest rates on high-yield bond funds or municipal bonds because they are tax-exempt. Also, one has to pay the funds to manage the high-yield tax-free investments that affect the profits.

One has to carefully consider different strategies and understand the prospects of the mutual funds and rights reserved on tax-free funds to make an informed choice.