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Typically, a tax-free mutual fund is made up of municipal bonds and other government securities. Such securities are attractive to many investors because returns are tax free, often at both the state and federal levels. However, they also tend to provide lower pretax returns than comparable securities issued by nongovernmental entities. It is imperative that you consider total after-tax returns when you are comparing a tax-free fund with a taxable fund. Whether or not a taxable fund is a better choice for you will depend in large part on how much of your returns are likely to go directly to federal, state, and local taxes at the end of the year and whether you are subject to the alternative minimum tax.
To determine your approximate after-tax rate of return on a taxable investment, multiply your rate of return by 100 percent minus your tax rate:
Pretax return x (100% - tax rate) = After-tax rate of return
For example, say you are in the 25 percent tax bracket and earn a pretax return of 10 percent on an investment. Your after-tax rate of return would be 7.5 percent, calculated as follows:
10% x (1 -.25) =.075 or 7.5% after-tax rate of return
In addition, consider whether the fund will be held in a qualified pension or retirement plan. If your returns will automatically accumulate tax deferred in an IRA or 401(k), there may be no reason to accept lower returns in exchange for a tax-free feature.
If you are risk averse, you may decide on a tax-free fund. The securities that it holds will be backed by the full faith and credit of the issuing bodies, typically state governments or municipalities. This feature coupled with the tax advantage gives some investors an added comfort level.
Note: Before investing in a mutual fund, carefully consider its investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing. Tax-free bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund's performance.