No one likes to pay taxes, but it’s a necessary part of living in a country which provides its citizens with a multitude of benefits. But just because you pay taxes doesn’t mean you can’t take advantage of available legal ways to keep your taxes low. Investors can enjoy tax-free income funds to grow wealth and minimize taxes.

What is a Tax-Free Income Fund?

Let’s break the definition down into two parts; tax-free and income. An income fund is a mutual fund or exchange-traded fund (ETF) which pays dividends to shareholders. Investors use this type of investment to create an income stream from their investments. A tax-free fund is an investment with dividends that aren’t taxed. These types of tax-free income funds are usually called municipal bond funds.

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. (For more, see: 5 Reasons to Invest in Municipal Bonds When the Fed Hikes Rates.)

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 25% federal marginal tax bracket. His state tax bracket is 4.5%. His total state plus federal tax rate is 29.50%. He has access to The Franklin California Tax-Free Income Fund Class A (FKTFX) and can buy it with no transaction fee through his Fidelity Investments 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%. (For more, see: How Your Tax Rate Is Determined.)

Simon can get a taxable Securities and Exchange Commission (SEC) yield, or rate of return, of 4.88% if he invests in Vanguard Long-Term Corporate Bond Index Fund Admiral Shares (VLTCX). But which investment offers the best after tax return? Given Simon’s 29.50% 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 are 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. (For more, see: Top 4 Muni New York Mutual Funds.)

Best Tax Free Income Funds

At present municipal bond tax-free income funds 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. Performance figures below are as of Dec. 10, 2015.

Best Tax-Free Income Funds

 

 

High-Yield Muni Bond Funds         

        Performance  (1-year)

Expense Ratio

American High-Income Municipal Bond Fund (AMHIX)

4.33% 

 0.68%

MFS Municipal High Income Fund (MMHYX)

5.18%

0.69%

Columbia High Yield Municipal Fund (LHIAX)

5.20%

0.87%

 

 

 

Muni California Intermediate-Term Bond Funds

 

 

Vanguard Calif. Intermediate Term Tax Exempt Fund (VCAIX)

2.96%

0.20%

Schwab California Tax-Free Bond Fund (SWCAX)

2.90%

0.49%

Principal California Municipal Fund (SRCMX)

3.93%

0.77%

 

 

 

Muni California Long-Term Bond Funds

 

 

T. Rowe Price California Tax Free Bond Fund (PRXCX)

3.25%

0.49%

Nuveen California Municipal Bond Fund (NCAAX)

4.54%

0.77%

USAA California Bond Fund (USCBX)

3.96%

0.57%

 

 

 

Muni Massachusetts Bond Funds

 

 

Fidelity Massachusetts Municipal Income Fund (FDMMX)

3.54%

0.46%

Vanguard Massachusetts Tax-Exempt Fund (VMATX)

3.57%

0.16%

AB Municipal Income Fund II Mass. Portfolio (AMAAX)

3.91%

0.77%

 

 

 

Muni Minnesota Bond Funds

 

 

SIT Minnesota Tax Free Income Fund (SMTFX)

3.29%

0.82%

Fidelity Minnesota Municipal Income Fund (FIMIX)

3.01%

0.49%

Columbia Minnesota Tax-Exempt Fund (IMNTX)

3.38%

0.83%

 

 

 

Muni National Intermediate-Term Bond Funds

 

 

State Farm Municipal Bond Fund (SFBDX)

3.13%

0.15%

Wells Fargo Advantage Core Builder Series M (WFCMX)

3.47%

0.00%

Vanguard High Yield Tax Exempt Fund (VWAHX)

3.75%

0.20%

 

 

 

Muni National Long-Term Bond Funds

 

 

USAA Tax Exempt Long Term Fund (USTEX)

3.36%

0.55%

T. Rowe Price Summit Municipal Income Fund (PRINX)

3.31%

0.50%

T. Rowe Price Tax Free Income Fund (PRTAX)

3.14%

0.51%

 

 

 

Muni National Short-Term Bond Funds

 

 

U.S. Global Investors Near-Term Tax-Free Fund (NEARX)

1.58%

0.45%

Invesco Limited Term Municipal Income Fund (AITFX)

1.65%

0.38%

Vanguard Limited Term Tax Exempt Fund (VMLTX)

1.07%

0.20%

 

 

 

Muni New Jersey Bond Funds

 

 

T. Rowe Price New Jersey Tax Free Bond Fund (NJTFX)

2.78%

0.51%

Vanguard New Jersey Long Term Tax Exempt Fund (VNJTX)

1.49%

0.20%

Eaton Vance New Jersey Municipal Income fund (ETNJX)

1.90%

0.74%

 

 

 

Muni New York Intermediate-Term Bond Funds

 

 

Franklin N.Y. Intermediate Tax-Free Income Fund (FKNIX)

2.81%

0.66%

Western Asset Intermediate Maturity NY Munis Fund (IMNYX)

2.56%

0.75%

Columbia AMT-Free

N.Y. Intermediate Muni Bond Fund (LNYAX)

2.49%

0.75%

 

 

 

Muni New York Long-Term Bond Funds

 

 

T. Rowe Price New York Tax Free Bond Fund (PRNYX)

3.48%

0.49%

Vanguard New York Long Term Tax Exempt Fund (VNYTX)

3.73%

0.20%

Columbia New York Tax-Exempt Fund (COLNX)

3.88%

0.78%

 

 

 

Muni Ohio Bond Funds

 

 

Vanguard Ohio Long Term Tax Exempt Fund (VOHIX)

3.99%

0.16%

Fidelity Ohio Municipal Income Fund (FOHFX)

4.30%

0.48%

Franklin Ohio Tax-Free Income Fund (FTOIX)

3.94%

0.63%

 

 

 

Muni Pennsylvania Bond Funds

 

 

Fidelity Pennsylvania Municipal Income Fund (FPXTX)

3.43%

0.49%

Vanguard Pennsylvania Long Term Tax Exempt Fund (VPAIX)

3.89%

0.20%

Wells Fargo Advantage Pennsylvania Tax-Free Fund (EKVAX)

3.88%

0.74%

 

 

 

Muni Single-State Intermediate Term Bond Funds

 

 

Fidelity Michigan Municipal Income Fund (FMHTX)

3.67%

0.48%

Colorado Bond Shares A Tax Exempt Fund (HICOX)

4.47%

0.70%

Dupree Alabama Tax Free Income Series Fund (DUALX)

3.13%

0.81%

 

 

 

Muni Single-State Long-Term Bond Funds

 

 

T. Rowe Price Maryland Tax Free Bond Fund (MDXBX)

3.35%

0.45%

T. Rowe Price Georgia Tax Free Bond Fund (GTFBX)

3.42%

0.53%

T. Rowe Virginia Tax Free Bond Fund (PRVAX)

3.20%

0.47%

 

 

 

Muni Single-State Short-Term Bond Funds

 

 

Fidelity California Limited Term Tax-Free Bond Fund (FCSTX)

1.51%

0.49%

Dupree Kentucky Tax-Free Short-to-Medium Series (KYSMX)

1.22%

0.74%

Thornburg California Limited Term Municipal Fund (LTCAX)

1.40%

0.94%

 

 

 

Source: U.S. News & World Report Best Mutual Funds-Municipal Bond Rankings

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. Just make sure to buy the municipal bond funds in accounts outside of your 401(k) plan, 403(b) or individual retirement account (IRA) to reap the best benefit of the tax free yield. (For more, see: ETF Analysis: iShares National AMT-Free Muni Bond.)

 

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