Everybody has to pay taxes but there's no reason not to take advantage of every available legal way to keep your taxes low. Tax-free income funds are one way to grow wealth while minimizing taxes.

What Is a Tax-Free Income Fund?

There are two separate factors here: tax-free and income.

  • An income fund is a mutual fund or exchange-traded fund (ETF) which pays dividends to shareholders. They are used by investors to create an income stream from their investments.
  • A tax-free fund is an investment that pays dividends that are not taxable.

These types of tax-free income funds are usually municipal bond funds.

Key Takeaways

  • Tax-free funds and ETFs are invested in municipal bond funds.
  • Like any income fund, their primary purpose is to provide a steady stream of income to the investor.
  • Whether you're better off with a tax-free or taxable income fund depends largely on your tax bracket.

If you’re in a higher tax bracket, a tax-free income fund which contains tax-free municipal bonds from your state can be a wise investment choice.

But before getting swept away with the idea of investing in a tax-free income fund, consider your own tax bracket.

Tax Equivalent Yield

You need to determine whether you’ll benefit from investing in a tax-free income fund. Start out by considering your marginal tax rate. Next, compare the rate of return on comparable tax-free and taxable income funds. Finally, calculate which investment is likely to give you a higher after-tax return.

For example, Simon lives in California and is in the top 24% federal marginal tax bracket. His state tax bracket is 10.3%. His total state plus federal tax rate is 34.3%.

He has access to The Franklin California Tax-Free Income Fund Class A (FKTFX) and can buy it with no transaction fee through his brokerage account. The 30-day yield, or rate of return, is 2.39%. Simon knows he can get a tax free return for approximately 2.39%. 

Or, Simon can get a taxable yield, or rate of return, of 4.88% if he invests in Vanguard Long-Term Corporate Bond Index Fund Admiral Shares (VLTCX).

Compare Net Returns

Which investment offers the best after-tax return? Given Simon’s high tax bracket let’s see if he’s better off investing in the 2.39% tax-free income fund or the 4.88% taxable income fund. Be aware that neither of the funds’ returns is guaranteed and they’re likely to fluctuate.

Simon’s 2.39% tax-free return is equivalent to a taxable yield of 3.337%. Any taxable return above 3.337% is preferable to the tax-free 2.39% return. Since he can earn a taxable return of 4.88% he’ll be better off in the taxable fund.

You can compare tax-free with taxable yields on this tax-equivalent yield calculator.

Best Tax-Free Income Funds

Municipal bond tax-free income funds can offer juicy yields. It’s not uncommon for their returns to top comparable taxable funds. Choose a fund issued with bonds from your state to compound your tax savings. Just remember that yields are subject to change and aren’t guaranteed. The performance figures below are as of Oct. 27, 2019.

Best Tax-Free Income Funds

High-Yield Muni Bond Funds         

Performance  (1-year)

Expense Ratio

Invesco Oppenheimer Rchst AMT-FrMncpl Fd (OPTAX)

 

9.22%

 

 1.03%

Nuveen High Yield Municipal Bond Fund (NHMAX)

 

8.59%

1.12%

Invesco Oppenheimer Rchst HYMncplFd (ORNAX)

 

11.26%

1.04%

 

Muni National Intermediate-Term Bond Funds

Performance

Expense
Ratio

State Farm Municipal Bond Fund (SFBDX)

 

6.53%

0.16%

Wells Fargo CoreBuilder Shares Series M (WFCMX)

 

8.08%

n/a

Vanguard Intermediate-Term Tax-Exempt Fd (VWITX)

 

6.94%

0.17%

 

Muni National Long-Term Bond Funds

 

Performance

Expense
Ratio

 

Vanguard High Yield Tax Exempt Fund (VWAHX)

8.04%

0.17%

Vanguard Long Term Tax Exempt Fund (VWLTX)

8.0%

0.17%
Eaton Vance National Municipals Inc Fd (EANAX) 7.01% 0.88%
 

Muni National Short-Term Bond Funds

 

Performance

 

Expense
Ratio

Capital Group Core Municipal Fund (CCMPX)

5.15% 0.34%

Capital Group Short-Term Municipal Fund (CSTMX)

3.66% 0.30%
Vanguard Limited Term Tax Exempt Fund (VMLTX) 4.09% 0.17%
 

Muni Single-State Intermediate Term Bond Funds

 

Performance

 

Expense
Ratio

Northern Arizona Tax Exempt Fund (NOAZX)

7.18% 0.47%
Segall Bryant & Hamill Colorado TaxFr Fd (WTCOX) 6.2%

0.65%

Dupree Alabama Tax-Free Income Series Fd (DUALX) 6.65% 0.70%
 

Muni Single-State Long-Term Bond Funds

 

Performance

 

Expense
Ratio

T. Rowe Price Maryland Tax-Free Bond Fd (MDXBX)

6.18% 0.48%
Fidelity® Michigan Municipal Income Fund (FMHTX) 7.19%

0.48%

T. Rowe Virginia Tax Free Bond Fund (PRVAX) 5.85% 0.51%
 

Muni Single-State Short-Term Bond Funds

 

Performance

 

Expense
Ratio

Invesco Oppenheimer-
RchsLitdTmCAMncpl Fd (OLCAX)

7.69% 0.98%
Invesco Oppenheimer Rcst® LtdTmNYMunis (LTNYX) 8.49% 1.03%
Fidelity® California Ltd Trm Tax-Fr BdFd (FCSTX) 4.22% 0.35%

The Bottom Line

If you’re looking for holdings for the fixed-income portion of your investment portfolio, these tax-free income funds may fit the bill. Buy the municipal bond funds in accounts outside of your 401(k) plan, 403(b) or individual retirement account to maximize your tax-free yield.