Municipal bond funds

A municipal bond fund is another kind of tax-advantaged mutual fund. A municipal bond fund invests in bonds issued by state, county, city, and other local government agencies. Most income from these bonds is exempt from federal income taxes (although you must report the income on your federal income tax return). If you live in a state that levies a high state income tax, such as New York, California, or Massachusetts, you may want to consider a single-state fund, which invests in municipal bonds issued only in that state. Income from such a fund is exempt from state taxes as well as federal taxes, and may even be exempt from local taxes in a city (like New York) that levies a local income tax. Over 600 such single-state funds are currently available, covering some 30 states.
Despite the tax advantages of single-state funds, they’re not for every investor. Some single-state portfolios are relatively risky. Because the fund manager is restricted to buying bonds issued in one state only, he may be forced to invest in some counties or government agencies whose credit is shaky. If the agency defaults on its obligations — that is, if it fails to make timely payment of the interest due on its bonds — the value of the portfolio may suffer significantly. Study the prospectus of any municipal bond fund you are considering buying, and make sure you understand the degree of safety or risk involved with the bond investments held in the portfolio.
If safety is especially important to you, consider a municipal bond fund that invests only in insured bonds. These are bonds guaranteed by an independent agency that promises to make timely interest payments if the issuing agency runs into financial difficulties.
The prospectus for any fund you’re considering states whether the portfolio includes insured bonds. The safety does come at a cost; generally speaking, an insured bond fund has a return that is 0.1% to 0.4% lower per year than an uninsured bond fund. You have to decide whether this lower return is a reasonable trade-off for you.
Although interest and dividends from municipal bond funds are not taxable, capital gains (if any) generally are. Be careful to distinguish the different forms of income and treat them correctly on your tax return.