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Tax-exempt mutual funds are simply composed of investments that generate tax-free interest. They are offered by many prominent investment firms, and some even specialize in this type of vehicle (see Top Mutual Funds from American Funds' Tax Exempt Bond).

What Is a Mutual Fund?

A mutual fund is a type of highly liquid security that's highly popular among retail investors. Though a mutual fund is technically a type of investment company, the term is most often used to refer to the fund's portfolio.

Mutual funds allow many investors to pool their money, thereby leveraging their combined investing power. Investors purchase shares of the fund, which entitles them to a portion of its proceeds. The fund invests shareholder contributions into a range of securities, most commonly stocks, bonds and short-term debt, and distributes the profits to the investors according to the size of their ownership stakes.

Types of Funds

There are four primary types of mutual funds: stock, bond, balanced and money market. As their names imply, both stock and bond funds are comprised of investments in the equity and debt markets, respectively. Bond funds, like bonds themselves, tend to be very stable and produce slow but steady income over time. Stock funds can be tailored to a variety of investment goals, from a high-risk, high-reward strategy to a diversified portfolio focused on minimizing loss potential.

Balanced funds include a combination of these two securities; usually the bond holdings temper the stocks, to provide a medium amount of risk. Commonly called cash equivalents, money market funds are comprised of investments in short-term debt securities, such as Treasury bills (T-bills) and commercial paper, that mature within three months.

Tax-Exempt Funds

Mutual funds invested in government or municipal bonds, called munis, are often referred to as tax-free or tax-exempt funds because the interest generated by these bonds is not subject to income tax. In some cases, bonds issued in your state of residence may be triple-tax-free, meaning interest is exempt from all state, local and federal income taxes. However, not all bonds are exempt from all taxes. While the interest on some bonds is exempt from state or local income tax, it may still be subject to federal income tax, as is the case with Treasury bonds (T-bonds).

Because tax-exempt mutual funds are comprised of government-issued bonds, which are virtually risk-free, they tend to have much lower rates of return than funds that include more volatile securities. For some, the tax benefits of these assets outweigh their reduction in earning potential. Whether this trade-off is beneficial largely depends on your income tax rate and how much your investment could be earning in a taxable fund.

When considering an investment in mutual funds, it is important to know the specific tax implications of each fund, to ensure you are not blindsided by a tax bill on an investment that is advertised as tax-free.

Capital Gains

While the interest on government bonds is often tax-free, any capital gains realized when the bond is sold at a premium are not. Because investors in mutual funds have no control over when bonds are bought and sold, there is the potential for an unexpected tax bill if the fund generates a profit from capital gains rather than interest.

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