Tax-Free Bond Funds

Bond investors who wish to decrease their tax burden can pursue income that is free of federal, state, and even local taxes. Income earned from municipal bond funds is free of federal tax. Income generated from state municipal bond funds is exempt from federal, state, and sometimes local taxes for residents of that state.

Who Can Benefit?

Investors in higher federal tax brackets or residents of high-tax states can realize a significant overall tax advantage by including tax-free bond funds in their portfolio. Although tax-free bond funds typically yield less than their taxable counterparts, investors accept a lower yield because they don't have to pay federal (and perhaps state and local) taxes on the income. Depending on the investor's tax bracket, tax-free bonds may provide higher after-tax income. The following chart shows that as your effective tax rate rises, the value of tax-free yield to you also increases.

Federal Tax-Exempt vs. Taxable Yield
Your Taxable Income (2012)*
A Tax-Exempt Yield of:
  3% 4% 5% 6% 7%
Federal Tax Rate Is Equivalent to a Taxable Yield of:
25.0% 4.00% 5.33% 6.67% 8.00% 9.33%
28.0% 4.17% 5.56% 6.94% 8.33% 9.72%
33.0% 4.48% 5.97% 7.46% 8.96% 10.45%
35.0% 4.62% 6.15% 7.69% 9.23% 10.77%

Effective 1/12

*This chart is for illustrative purposes only and does not represent the performance of any specific security. Net amount subject to federal income tax after deductions and exemptions.

A Word About the Alternative Minimum Tax (AMT)

Since the AMT income levels are not adjusted for inflation, more taxpayers are affected every year. While you should consider the impact of the AMT, it should not be the primary factor in your investment decision. You can minimize your AMT liability by choosing AMT-free municipal bonds, spreading gains over several years, and planning your income and deductions.

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