A:

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, also 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.

RELATED FAQS
  1. Mutual funds vs. money market funds

    Learn what a mutual fund and a money market fund are, understand the differences between each, and how they serve various ... Read Answer >>
  2. Are mutual funds considered cash equivalents?

    Find out why only money market mutual funds are considered cash equivalents, and learn a breakdown of the different types ... Read Answer >>
Related Articles
  1. Investing

    What You Need to Know About Mutual Funds

    Mutual funds are a good investment opportunity, but investors should know how they operate.
  2. Investing

    How Tax-Efficient Is Your Mutual Fund?

    Learn about factors that influence the tax-efficiency of your mutual fund, how income from your investment is taxed and what to look for when choosing a fund.
  3. Investing

    Bond Funds Boost Income, Reduce Risk

    Bond funds can provide stable returns for those who depend on their investment income.
  4. Financial Advisor

    Is Your Financial Advisor Picking the Right Mutual Funds?

    Learn about the different types of mutual funds and how to know if your financial advisor is choosing the right funds for you based on your investment goals.
  5. Financial Advisor

    Tax-Free Income Funds You Should Shortlist (FKTFX, VLTCX)

    Looking for holdings for the fixed-income portion of your investment portfolio? These top tax-free income funds may fit the bill.
RELATED TERMS
  1. Bond Fund

    A bond fund is a fund invested primarily in bonds and other debt ...
  2. Tax-Exempt Sector

    The tax-exempt sector is a market niche comprised of investment ...
  3. United States Treasury Money Mutual Funds

    A United States Treasury money mutual fund is a mutual fund that ...
  4. Mutual Fund Yield

    Mutual fund yield is a measure of the income return of a mutual ...
  5. Income Fund

    A type of mutual fund that emphasizes current income, either ...
  6. Double Exempt

    The status accorded to municipal bonds for which interest is ...
Hot Definitions
  1. Return on Assets - ROA

    Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
  2. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  3. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  4. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  5. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  6. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
Trading Center